Market Cycles – a behavioural perspective

The times they are a-changing. As one astute observer wrote recently to a newspaper, once upon a time, we shopped on the high street and recovered with a cup of coffee at home. Now we shop at home and then head to the high street to recover over a cup of coffee.

Yet some things appear never to change, and looking through stock market charts I am always reminded of Mark Twain’s alleged comment that “history doesn’t repeat itself but it often rhymes.” One certainly notes similar patterns in the rises and falls over time, simplistically described as a four-phase sequence as the bottoming of a market becomes a bull market, continuing towards a topping of prices and finally to a bear market. Each phase, of course is interspersed with volatility and reversals, and can take place over a variety of time frames. Market cycles, like economic ones, are the subject of much academic literature, and phases are sometimes characterised, for example, as moving from ‘accumulation’ to ‘mark-up’ to ‘distribution’ to ‘mark-down.’

From a behavioural perspective, it may more helpful to look market cycles in terms of an emotional cycle, something easy with hindsight but which only the best investors appear able to do with predictive ability. “Be fearful when others are greedy and greedy when others are fearful,” advises Warren Buffett, based on the eternal truth that sentiment is usually depressed at the bottom and too optimistic at the top. For a more romantic adage from the nineteenth century, I prefer Nathan Rothschild’s “buy when you hear the sound of the cannons, sell when you hear the trumpets.”

In 1999, near the top of the longest bull market in history, a book by a Wall Street expert called Dow 100,000 Fact or Fiction? was published. That forecast an index level of 80,000 in 2018 and 100,000 in 2020. The author was perhaps deafened by the trumpets.

At the other extreme, in early 2009, as the cannons of the global financial crisis continued to roar, stock markets actually and suddenly turned sharply upwards and have risen strongly ever since. The fear expressed by most commentators about economic Armageddon have gradually become replaced by hope and then, almost reluctantly, increased optimism – it is notable that at time of writing that current stock prices are often described as reflecting “the most hated bull market ever” – which certainly suggests that we have not reached the general euphoric mood that traditionally characterises market tops, despite examples of possible bubbles in specific stocks. Nevertheless, there are warning signals, not least if one looks at cyclically adjusted price earnings ratio (‘CAPE’) in the US which stands above the 1929 peak but below that of 1999.

Do the lessons of history suggest that investors are generally fickle? Only in the sense that they are human beings who have hopes and fears, and that these are reflected as much in their financial decisions as any other part of their lives. There are usually good adaptive evolutionary reasons for most of the mental shortcuts we make, such as the bandwagon effect, better known as herd instinct – in the environment in which most humans have lived for hundreds of thousands of years, this makes sense. But such instincts, in a newish ‘artificial’ environment like a financial market place, may be inappropriate, especially if they are exaggerated towards the end of a market cycle – for example, many studies of mutual fund flows show that the heaviest capital inflows typically chase asset classes that have already risen in value, often in the later stages of a bull market.

In a nutshell, we tend to be ‘momentum’ and ‘growth’ rather than ‘value’ investors; a recent Morningstar Direct survey of 1,405 global equity funds estimated that 93% of the assets were growth focused. There is, of course, nothing intrinsically wrong with the growth and momentum approaches – indeed many professional investors successfully specialise in these concepts – but it can be a risky strategy for lay investors who unknowingly play the market in the later phases of a bull market cycle. Instead of the desirable intention to buy near the bottom and sell at the top, the danger is that they do the reverse.

Thankfully, in the words of psychologist Gary Marcus, “nature bestows upon the new born a considerably complex brain, but one that is best seen as prewired – flexible and subject to change – rather than hardwired, fixed and immutable.”

So what can an investor do to counteract our prewired biases? First, just being aware we all have biases is a good start. And we have hundreds of them. One of the most prevalent mental short cuts (a good definition of a bias) is confirmation bias: the idea that we typically tend to seek and overvalue evidence that supports our viewpoint rather than ask the question posed by the best investors: “Where could I – or indeed the herd – be wrong?” Instead too many of us are like the Boxer of Simon & Garfunkel fame: “Still a man hears what he wants to hear, and disregards the rest.”

Historical giants like Benjamin Franklin and Charles Darwin were renowned for weighing up alternatives when it came to big decisions. Charles Darwin even drew up a list of pros and cons of marriage, that ranged from the sensible “constant companionship and friend in old age” to the silly “better than a dog, anyhow.” A curious mind that allows one to challenge one’s own view has certainly been a personality trait of the best investors with whom I have worked in the last three decades.

The nature of our changing emotions associated with different phases of any financial cycle – exacerbated by the salience of recent events and the inevitable media comment – means that an investor should be no different in attitude, constantly considering a devil’s advocate position on matters of significance. This will add a little extra time to a decision-making process (and it does require effort), but it will certainly improve it and help to reduce the amplitude of our emotional cycle.

And it will help us distinguish between the sound of the cannons and the trumpets.