Cyclicality is a common theme that runs through the philosophies of many great investors. Gurus like Warren Buffett (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Howard Marks (Trades, Portfolio), while practicing distinctly different styles of investing, all fundamentally believe cycles govern market behavior. In his book "The Most Important Thing," Marks explains that human psychology lies at the root of these cycles.
He wrote that while investing is inherently highly uncertain, there are two rules he believes hold pretty steadily:
“Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”
Economies, markets and companies naturally go through cycles. Bull runs yield to bearish corrections, and then the pendulum swings back. For many people, however, this is a difficult concept to grasp. There is a point during every protracted bull market where someone declares this is the new normal. Similarly, during depressed periods, many people are fearful of investing as they believe asset prices may never recover. It is this human variability that causes cycles in the first place. Marks wrote:
“The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main rea-son for this, I think, is that people are emotional and inconsistent, not steady and clinical.
Objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.”
Good times create profligate spenders. When consumers come to believe the boom is here to stay, they tend to spend more and save less. They increase their leverage and use debt to fund non-essential aspects of their life. Ironically, it is this behavior that brings about the end of the cycle. As Marks noted:
“All of these things are capable of reversing in a second; one of my favorite cartoons features a TV commentator saying, 'Everything that was good for the market yesterday is no good for it today.' The extremes of cycles result largely from people’s emotions and foibles, nonobjectivity and inconsistency.”
Although there is a certain grim inevitability about all of this, investors should cheer the cycle. Human variability is the reason why stocks can become mispriced in the first place.
Read more here:
- The Rise of the Living Dead
- Warren Buffett: Derivatives Are Dangerous
- Morgan Stanley: 3 Sources of Uncertainty
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