Market Cycles Will Endure as Long as Humans Exist
(Bloomberg Opinion) -- Financial historians have written about the cycles of the past, and investment strategists write about the cycles of the present. But what about the next cycle? And the one after that? Will there even be cycles in the future, or have they become outmoded?
Economies and markets have never moved in a straight line in the past, and neither will they do so in the future. To understand what the future holds in terms of cycles, investors first have to understand why cycles happen, where they stand in the current one, and what they can learn from it.
Four of the most dangerous words in the investment world are “It’s different this time.” When people use them, what they’re saying is that the norms of the past no longer apply. In 2000, people swallowed the assertion that even though the price-to-earnings ratio on stocks had averaged 16 for 50 years, the wonders of technology had rendered that restraint irrelevant, and thus the current ratio of 32 was totally appropriate. And in 2007, they accepted that Wall Street financial engineering and the Federal Reserve’s adroit management of the economy had either eliminated investment risk or caused it to be “sliced and diced” so finely, and distributed so broadly, that investors no longer had to worry about it. Both these notions were soon shown to have been erroneous, and the market bubbles abetted by that optimistic thinking were popped, bringing on painful market crashes.
And that brings me to the future of cycles. Every once in a while, when the economy and the markets are humming, there arises another belief that things are now different: that cycles have been put to an end, such that we no longer have to worry about the upswing turning into a downswing. For example, in pre-Depression 1929, an auto company president declared, “There will be no interruption of our present prosperity.” In 1996, while the tech bubble was building, the Wall Street Journal reported, “The big, bad business cycle has been tamed.” And former Treasury Secretary and New York Federal Reserve President Tim Geithner wrote in his autobiography, “Stress Test: Reflections on Financial Crises,” that in 2003, on the way to the global financial crisis, “There was growing confidence that [financial innovations and better monetary policy] had made devastating crises a thing of the past.”
In other words, the assumption was that good times in the economy can roll on forever; assets can appreciate without end; and investors needn’t worry about a correction, bear market or crash. Such “different-this-time” thinking is sorely wrong and potentially dangerous.
So why do people return to such thinking over and over again? For the same reason that market cycles exist. They arise not from the operation of some mechanical process or economic law, but rather from excesses committed by participants. Emotional and psychological swings cause investors to overreact favorably to fundamental developments. Producers and consumers conclude that the economic future will always be rosy, causing them to add too much productive capacity and to borrow and buy too much. Similarly, optimism and euphoria cause investors to assume that the economy will always grow, corporate profits will always rise, companies will continue to succeed, and asset prices will never reach a point where they overstate the coming good news and thus are ripe for a downward correction.
The news and the outlook can never be so good that the psychology can’t be too optimistic, causing prices rise too high, necessitating a correction. On the other hand, if investors worry too much about bad news, their excessive negativism can send asset prices so low that recovery will inevitably follow.
Economies grow and markets rise in the long term, but emotion brings on responses that are excessive on the upside, invariably leading to corrections on the downside. This process will go on as long as economies and markets are driven by people, and as long as people’s behavior is ruled by their emotions — which means forever. Cycles are with us. Thus it’s incumbent upon us to understand how they operate and make that knowledge our tool, not the source of trouble.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Howard Marks is chairman and cofounder of Oaktree Capital Management. This piece is adapted from a chapter that appears in his new book Mastering the Market Cycle: Getting the Odds on Your Side
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