Will the Market Pendulum swing back?

For centuries people have tried to understand the movements of the share market, sometimes with little success. Sir Isaac Newton, for example, lost a fortune in the South Sea Bubble and said, ‘I can calculate the motion of heavenly bodies, but not the madness of people’.

One analogy that describes aptly the movements of the share market, is that of the pendulum.

In the scientific world, a pendulum is an object suspended from a fixed point that swings back and forward under the influence of gravity. As pendulums move in precise time intervals, they are particularly useful in clocks, as they enable the clock to accurately keep time.

It’s true that the share market’s movements aren’t quite as graceful as that of a clock, but the analogy still works.

The great investor Benjamin Graham once said, ‘The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists’.

Another who has spoken at length about the pendulum, is author and investor Howard Marks. In his book The Most Important Thing, he has a chapter titled ‘Awareness of the Pendulum’, where he wrote that the oscillation of the market pendulum is, ‘one of the most dependable features of the investment world’.

At one extreme of the pendulum there is euphoria, greed, excessive risk taking, and high prices. And at the other extreme there is depression, fear, risk-aversion, and low prices.

As with the pendulum, when the share market reaches its extremities, it doesn’t stay there long, but inevitably moves back towards the middle (where it doesn’t stay long either). The market in fact, spends most of its time moving towards or away from its extremities.

Investor Psychology

The psychological forces that impact investors tend to occur near the market’s extremities.

At the top of the market, there’s an abundance of greed and overconfidence. Envy can also be a factor, as those who watch their friends get rich, may decide to jump in too.

At the bottom of the market, fear is the dominant emotion which can cause people to sell and crystalise their losses at exactly the wrong time.

The Herding Instinct, which is the natural drive to ‘follow the herd’, can also cause havoc near the market’s extremities, resulting in people buying high and selling low.

The GFC

Every market cycle shows clearly how the pendulum works, and how attitudes towards risk change.

Howard Marks believes that there are two main risks in investing. They are: 1. The risk of losing money, and 2. The risk of missing opportunity.

The risk of losing money is what concerns investors at the bottom of the market, and the risk of missing opportunity is the main concern at the top of the market.

In the year before the Global Financial Crisis, investors were optimistic and upbeat. People felt positive about the future, and markets were at all-time highs. The primary fear was the fear of missing out on opportunities.

As bad news began to filter into the market in mid-2007, the approach to risk changed. In a short time, the primary risk became that of losing money. As the bankruptcies and bad news gained pace, so did the desire for investors to rush for the exits.

However, the selling was overdone, and a unique buying opportunity emerged. By early 2009 the share market had bottomed, and the pendulum began to swing back the other way. It started with just a few investors buying, followed by a few more, and finally everyone was buying, and the market recovered.

Opportunities

Understanding the market pendulum, can give investors an edge, as the best buying opportunities often occur while fear is at its highest.

In recent times, the share market pendulum has certainly swung to the ‘fear’ end of the arc. Whether it has reached its absolute bottom yet, we don’t know. What we do know, is that if history (and the pendulum) is our guide, the market will eventually swing back to new all-time highs. We just don’t know when.

So, when is the best time to buy?

Howard Marks said, ‘It’s my view that waiting for the bottom is folly. What then should be the investor’s criteria? The answer is simple: if something is cheap – based on the relationship between price and intrinsic value – you should buy, and if it cheapens further, you should buy more’.