Where are we now? It’s a question often asked about the stock market cycle that leaves everyone wanting. That’s because the nature of markets makes precise answers impossible.
So instead, most responses come in the form of analogies. Baseball innings are a popular one. “What inning is the market in today?” “The seventh inning, hope that helps.”
A pendulum swinging back and forth is a better example. Howard Marks uses it in both of his books to describe the market cycle. Edwin Lefevre even used it back in 1901.
Robert Kirby, an investment adviser who conceived of the coffee can portfolio, gave one of the better descriptions of the market pendulum during a talk in April 1999:
Long ago, I began to look at the stock market as a kind of pendulum swinging back and forth with no discernible pattern or rhythm. It swings between three o’clock on one side and nine o’clock on the other. At three o’clock, fear takes over and it’s full panic. At nine o’clock, greed takes over and it’s full manic. At six o’clock there’s a point where logic and balance exist and where valuations make a lot of sense to most rational people. Unfortunately, the pendulum doesn’t spend much time at six o’clock. If you’ve been in this business 40 or 50 years you can probably look back on three or four months — an accumulation of a number of two or three week intervals — where it’s six o’clock and prudent men seem to be in control…
In looking back over the years, I am shocked, but I guess not surprised, that every time the pendulum has swung over toward nine o’clock, the best and brightest minds in the business have focused on finding a rationalization or an explanation of why the mania of the moment really made sense. Today, of course, the mania of the moment is the Internet. Oddly, the strongest advocates of the Internet stocks are those who believe that the only way to investing success is to buy companies with the strongest possible earnings momentum. They don’t seem to be particularly fazed by the fact that most of the Internet stocks have no earnings. Claims that the meteoric flight of the Internet stocks is the product of many, undisciplined, inexperienced, day traders is a bunch of baloney. A recent “Wall Street Journal” article showed the degree to which Internet stocks have increasingly entered the portfolios of mutual funds. This increase has been dramatic over the past four to six quarters. I had to go lie down with a cold compress on my forehead when I read that over 20% of domestic equity mutual funds own America Online. No one would deny that the Internet and the world wide web are having and will continue to have a huge impact on the world’s economy and on the lifestyles of everyone in it. However, I am not at all sure that it is greatly different than the development of the telephone or the television or the automobile or the transistor. All of these inventions caused dramatic change and huge growth but all in due course, as is true of most industries, ended up with at least ten failures for each success and with an oligopoly dominated by a handful of mature companies…
My point in all this is that the market is screwy most of the time. Today it is particularly screwy.
The pendulum concept helps explain much of what goes on in the stock market. It also is a perfect visual for how we should approach risk management and asset allocation.
As the pendulum moves closer to 3 o’clock, stocks are undervalued, the odds of higher future returns are highest, and risk is lowest. Investors should be aggressive, risk-tolerant, and optimistic because being heavily investing in undervalued stocks pays off in the long run.
As the pendulum gets closer to 9 o’clock, stocks are overvalued, the odds of higher future returns are lowest, and risk is highest. Investors should be cautious, risk-averse, and pessimistic because the most overvalued stocks tend to be serial losers over time.
But that’s not how things usually play out. The fact that the pendulum swings as far as it does in both directions is proof that most investors do the opposite. The trouble, as Kirby points out, is we often try to explain away why things are the way they are. We try to rationalize why the pendulum is closer to six when it’s really closer to the extremes. Basically, we’re great at making excuses for why undervalued or overvalued stocks are priced right. In the process, we fail to account for the possibility that the market reverts to the mean.
Instead, investors become more cautious or pile out of the market as the pendulum moves closer to three. And they become more optimistic and greedy, piling into the market as it moves closer to nine.
The end result is pain on both ends. They miss the opportunity off the lows and experience losses in the steep correction that follows overvalued markets.
The problem with the pendulum is that it’s imperfect. You never know how far or fast it swings. Bubbly, overvalued markets, like the Dotcom boom, can blow bigger than we expect. And the corrections, like the 1929 to 1932 crash, can fall farther than we anticipate.
The key to the pendulum analogy is to be aware of the risks and behavior that come with market extremes and that, eventually, those excesses revert, so you can adjust your portfolio to a more comfortable allocation. It’s meant to help manage risk not time the market.
I can rattle off several reasons why the market’s currently well past six o’clock — the increased public interest in markets, single reliance on past returns to pick stocks, increased gambling on options and penny stocks, limitless demand for (SPAC) IPOs…investing seems way easier than it really is. All of it has created some unrealistic expectations.
But how close are we to nine o’clock? Caution certainly seems appropriate but what if I’m wrong? (This doesn’t quite feel the same as 1999.)
It always pays to be a tiny bit greedy — not too much — when the markets closer to nine and a little cautious when the markets closer to three. Simply put, you’re never all in or all out of the market — adjust to a lower allocation to stocks at nine (higher at three) than normal. It’s a simple way to hedge against being wrong.
Source:
Tirade of a Dinosaur
Related Reading:
Defying Reversion to the Mean