Stock markets, at times, reflect more of what participants want to happen than what businesses are capable of doing. Hope, fear, and greed drive prices in the short run. Business success, or lack thereof, drive prices long term.
Market cycles reflect the shifting mix of the emotional side of market participants and the changing fundamentals of business. At the extremes, emotions carry more weight on market prices.
Behavior follows market prices, unfortunately. Like fanatics with their sports teams, we prefer winning stocks to losing stocks. Winning stocks are rising. Losing stocks are not. And when the market is winning, excitement grows.
The winning is inconsistent, of course. The market rise is pitted with random dips. Each dip a potential turn or pause before a new high. But as more dips lead to new highs, skepticism of a turn in the market cycle grows.
Bandwagon fans jump in as the wins pile up. The longer the market winning streak, the more we expect it to keep winning. In time, hope turns to greed and rising prices are all that matters.
Nothing lasts forever. The best teams, like the longest bull markets, see their dynasties end. However, emotions are slow to change. Skepticism still sees dips as opportunities to get richer, but dips lead to false rallies, and lower lows. Each dip down compounds the losses. Doubt turns to fear. Those that bought at any price in the run up to the peak, now sell at any price to end the emotional rollercoaster.
The decline gradually slows, ends, and reverses. Business fundamentals begin to carry more weight than emotions on market prices. Signs of business improvement, in excess of expectations, move prices higher. And the cycle renews.
There’s more to it than this, as the quotes below show, but here’s what matters about market cycles. There’s no uniformity. No fixed schedule exists. Bells don’t ring out at the turns. Bubbles and busts are not required. The causes and effects vary. All we have is a rough guide to how things might play out. Most of it become obvious only in hindsight.
For investors out there, the goal is not to know exactly when the cycle turns. it’s too unpredictable. Just know that:
- Markets do turn,
- Emotions and fundamentals play a role in the course of a cycle, and
- Letting the emotional side of markets influence your investment decisions can be expensive.
Your best defense is an investment plan built to take advantage of the emotional side, as much possible, throughout a full market cycle.
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The decades interposed between the great commercial crises are normal cycles of development of Credit under certain existing conditions; that during each of those decades commercial Credit runs through the mutations of a life, having its infancy, growth to maturity, diseased over-growth, and death by collapse; and that each cycle is composed of well-marked normal stages, corresponding to these ideas in nature and succession. And as Credit is a thing of moral essence, the external character of each stage of its development is traced to a parallel change of mental mood, and we find the whole subject embraced under the wider generalisation of a normal tendency of the human mind… The one important matter is the successional order, as first suggested by the fact of periodicity; and that order is important chiefly as a guide to parallel inductions, forming a gradus by which we may arrive at a true theory of cause.
In the course of our investigation, then, we shall probably find that the malady of commercial crisis is not, in essence, a matter of the purse but of the mind. And regret it as we may, it seems as if, for the present, these rapid mercantile mutations were as inevitable as the periodical tempests which clear the atmosphere of tropical regions. — John Stuart Mill (source)
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Periods of depression invariably follow periods of overoptimism, when fear replaces hope as the controlling emotion. — Edwin Lefevre (source)
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Bull markets and bear markets last long enough so that the average trader is likely to forget by the time the climax is approaching that any sort of movement is possible. — Philip Carret (source)
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Let me conclude with one of my favorite cliches — the French saying: “The more it changes the more it’s the same thing.” I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of this proverb is the phrase, “the more it changes.” The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliche is sound — as a cliche’s only excuse, I suppose, is that it is sound — then the stock market will continue to be essentially what it always was in the past — a place where a big bull market is inevitably followed by a big bear market. In other words, a place where today’s free lunches are paid for doubly tomorrow. — Ben Graham (source)
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Just as in the realm of pugilism, a few years of soft living will make a Dempsey easy prey for a Tunney, so a period of prosperity contains the seeds of its own destruction. — Philip Carret (source)
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All of the great investing periods begin when things are terrible and end when they are wonderful. The best time to buy stocks in the 1930’s was at the bottom of the Depression in July 1932; in the 1940’s, at the outset of World War II. In the 1970’s, you could not have done better than buy during late 1974, a time of rising rates and inflation, an oil embargo, recession, and a constitutional crisis with Watergate. The worst recession since the Depression hit in 1982. Rates were double digit, and inflation nearly so; Mexico defaulted on its debt, and a 17-year bull market was just beginning. — Bill Miller (source)
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One of the important factors behind the fluctuation between bull and bear markets, between booms and crashes and bubbles, is that investor memory has to fail us – and fail universally – in order for the extremes to be reached. — Howard Marks (source)
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Any market will gain respectability if it goes up high enough and any market will lose respectability if it goes down enough. — Arnold Van Den Berg (source)
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If the stock market has a period of outperformance of its long-term return, it is inevitably followed by some period of underperformance. But people being optimistic and greedy by nature take the recent short-term outperformance of stocks as a sign of good things to come, rather than a warning of bad things to come. — Seth Klarman (source)
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The history of markets is one of overreaction in both directions. But another interesting feature of that history is that the same objective fact appears entirely different when the market is going up from the way it appears when the market is going down. — Peter Bernstein (source)
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It is a safe prediction for me to make that, in future years as in the past, common stocks will advance too far and decline too far, and that investors, like speculators — and institutions, like individuals — will have their periods of enchantment and disenchantment with equities. — Ben Graham (source)
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there is one law I believe in, which I call elasticity. That is simply an intuitive nonscientific term for the law of regression to the mean. What goes up does not have to come down, but what goes up a lot more than everything else, frequently has to lay fallow for a long time while much else catches up. — Robert Kirby (source)
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It is an old cliché that they don’t ring a bell at the tops and bottoms of markets, but it is not entirely true. Occasionally someone climbs up in the belfry and does just that, as a public service, but knowing that few are likely to heed the bell. — Bill Miller (source)
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The important question for the investor is not whether conditions are good or bad (if, in fact, they can be measured on such a scale), but whether they are changing for the better or for the worse relative to expectations. — Arthur Zeikel (source)
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The market cycle will once more prove to be the human-nature cycle; its economic background will have changed, but not its basic character nor the consequences of its character. — Ben Graham (source)
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Boom–bust processes tend to be asymmetrical: booms are slow to develop and take a long time to become unsustainable, busts tend to be more abrupt, due to forced liquidation of unsustainable positions and the asymmetries introduced by leverage. — George Soros (source)
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As long as people are involved in the process, and given their tendency to take everything to the excess in the upward or the downward direction, there never will be permanent moderation. I have quotes from the Nineties about how we never will have recessions again, I have quotes from the Twenties about the fact that we are in an era of permanent prosperity. It’s all wishful thinking. The interesting thing here is: This discussion that current conditions are permanent always increases at high market levels. And when people encourage others to be optimistic, it’s always at high levels. But the people you want to follow in this world are the ones that encourage optimism at low valuation levels; those who say “cool it,” when prices go higher and higher. — Howard Marks (source)
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In Wall Street, what has happened before will happen again. It must, as you will admit if you stop to think about it. — Edwin Lefevre (source)
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It is not in the nature of economic reality to permit net gains at the shown rates from 1949 to 63 — something like 14% per annum including the dividend returns — to continue indefinitely in the future. We just don’t have a financial and economic system that can operate on that basis. If that were true nobody would have to work for a living. I remember very well the number of people in the late 1920’s who got a corresponding view of the stock market, gave up their jobs and plunged into Wall Street to take advantage of its wonderful future. — Ben Graham (source)
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When the rewards to risk and enterprise appear large, businessmen walk the earth with pride, boast about the superiority of our system, take excessive risks, and consequently tend to forget the inevitable uncertainty of outcomes in an unplanned system. When reality dawns and depression sets in, they hang their heads in shame and, obsessed with uncertainty, tend to forget the rich rewards that the system will pay to those with a spirit of enterprise and an appetite for risk.
Familiar as this analysis may be, two aspects of it are crucial to understanding the nature of the present crisis. They contain the ultimate truth of what our system is all about.
First, the system fluctuates between these two types of environments because each is the cause of the other. The easy attitude toward risk in the euphoric stage is what brings the good times to an end. Risk-aversion and caution eliminate the excesses and lay the groundwork for richer rewards ahead.
Second, human beings seem constitutionally incapable of remembering that this process of alternation is inevitable, even if its timing is difficult to predict. Indeed, one reason why the timing is so tricky is that people take so long to recognize change and to recall that it is inevitable. Yet what happens tomorrow will be different from what happens today precisely because we are making efforts today to adjust to whatever it was that happened yesterday. — Peter Bernstein (source)
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The whole reason that our capitalist system works the way it does is because there are cycles, and the cycles self-correct. — Seth Klarman (source)
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When things go badly, people become cautious. Then their caution causes things to go well, and when things go well, they become incautious. I think that’s a forever cycle. — Howard Marks (source)
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After the violence of a crisis has subsided, it becomes clear that it is not upon Capital, nor even upon legitimate commerce that the blow has fallen heaviest. As a rule, Panics do not destroy Capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works. — John Stuart Mill (source)
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The market cycle of the future may prove to be surprisingly independent of the business cycle, and it may even exist if there is no business cycle — which is in itself quite an assumption, but not an entire impossibility. — Ben Graham (source)
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