Why Market Cycles Will Never End

 Understanding cycles will give you the biggest investment opportunities.

This article is based on three different books. “The Most Important Thing” and “Mastering the Market Cycle” by Howard Marks and “Same as Ever” by Morgan Housel. All three are great books, so I strongly recommend giving them a read if you have the time.

We are linear thinkers. We like to think that trends continue. If something’s been going well, we think it will do well in the future. If it’s been performing poorly, we think that trend will continue. This may be true in the short term, but it is far from the truth in the medium to long term. In reality, most phenomena oscillate between good and bad, between greed and fear, and between euphoria and despair. It’s always been this way and it always will be.

Let’s start with an obvious example. Fluctuations between greed and fear in the stock market.

• Prices are low. A few astute investors realize this and start buying.

• The activity of these investors causes the market to go up slightly.

• The slight upswing in the market attracts more investors, who buy and push the market up.

• Now, the clear upward trend causes people to be optimistic, and the market goes up further. 

• The market reaches record highs and even those who normally do not invest buy in, usually out of envy.

• The last potential investor buys and the down cycle begins.

Almost everyone knows about the cycle described above. Yet, it always repeats itself. Over and over and over… Which prompts the question, why is that so?

Hyman Minsky, an economist at Washington University argued that booms and recessions will never disappear. He came up with what he called the financial instability hypothesis. It goes like this:

• When an economy is stable, people get optimistic.

• When people get optimistic, they take on debt.

• When they take on debt, the economy becomes unstable.

• When the economy is unstable, people reduce debt.

The interesting part here is that stability itself lays the ground for instability, and instability the ground for stability. Or in Morgan Housel’s words, “Calm plants the seeds of crazy”. 

Whether it be economies or markets, the lack of bad events themselves (stock market downfalls or recessions) are the cause of future bad events. But this principle does not just ground itself in human matters. Nature has these cycles too.

Prey and predator model, Britannica.

You might have seen this graph back in an ecology class. This graph depicts the change in population of the prey (hare) and predator (lynx) over time.

• Good times cause the hare population to rise.

• A high hare population means more food for the lynx. This causes the lynx population to rise.

• The rise in the lynx population means they consume more hares. This causes the hare population to decline.

• Fewer hares mean less food for the lynx. This causes the lynx population to decline.

• A decline in the lynx population means less danger for the hares. Good times are back again.

Cycles are a fact of life. We cannot avoid them, so might as well learn how to cope with them.

Understanding cycles comes in handy for investing, where there aren’t that many “sure things” that hold true all the time. Forecasts can be incorrect, the value of a company can dissipate, and unexpected events can pop up. Yet, there are two rules we can consistently rely on according to Howard Marks:

Rule 1: Most things will prove to be cyclical.

Rule 2: Some of the greatest opportunities for gain and loss come when other people forget rule number one.

Luckily for us, the human tendency to think linearly and follow recent trends causes people to forget rule number one. Every now and then, people declare the end to cyclicality. That is a sign to either be cautious –  if people think things will go up forever – or aggressive – if people think things will get worse forever.

You may think it's peculiar that people are unable to recognize such an obvious pattern. But linear thinking gets to the best of us:

• “I cannot help but raise a dissenting voice to the statements that… prosperity in this country must necessarily diminish and recede in the future.” (E.H.H. Simmons, President, New York Stock Exchange, January 12, 1928)

• “We are only at the beginning of a period that will go down in history as the golden age.” (Irving T. Bush, President, Bush Terminal Co., November 15, 1928)

• “The fundamental business of the country… is on a sound and prosperous basis.” (President Herbert Hoover, October 25, 1929)

Quotes from “The Most Important Thing”, Howard Marks.

In hindsight, this was the peak of history’s greatest stock market bubble and the beginning of the Great Depression. During this time, the stock market fell nearly 90% and unemployment reached 25%. This isn’t the only example. If you study market history, you’ll realize that declarations regarding the end of cyclicality usually precede the biggest crashes or the largest booms.

Again, moving away from linear thinking is hard. In good times, everyone else will be optimistic. All the economic data will be phenomenal. Equities will be rising. In bad times, the mood will be miserable. Economic data will be worse than ever. There will be no sign of hope. If you do not understand that good times are the primary cause of bad times and bad times the cause of good, it’s extremely difficult to think cyclically.  

“Success carries within itself the seeds of failure, and failure the seeds of success.”

 - Howard Marks

Second Level Thinkers (more on this article here) recognize cycles exist and use situations where cycles have reached extremes to their advantage. 

I will give my favorite investor, Howard Marks, the last word. “The next time you’re approached with a deal predicated on cycles having ceased to occur, remember that invariably that’s a losing bet.”