Michael Mauboussin is out with a new piece. In it, he lays out the ingredients that drive market cycles, both normally and to extremes, and how to cope with it.

The normal fundamentals that drive market cycles, when combined with our own biases, can lead to extreme asset prices.

Procyclical feedback loops commonly start with fundamental economic strenght taht becomes virtuously self-reforcing. For example, an increase in consumer demand leads to greater business investment, which leads to higher employment, which spurs additional demand. The process also works in the opposite direction.

Whether up or down, a trend in fundamentals can morph into a feedback loop that pushes asset prices to an extreme. While it is difficult to isolate the exact cause of a procyclical extreme, we can offer a taxonomy that captures much of the behavior we observe. The boundaries between these categories are blurred, but they reflect most of what we see in markets.

This is a normal part of the cycle. It’s only when irrational thought permeates that you see extremes like the Dotcom and the housing bubble and busts. Continue Reading…