The writer is co-founder and co-chairman of Oaktree Capital Management and author of ‘Mastering the Market Cycle: Getting the Odds of Your Side’
I have lived through (and been educated by) several significant cycles during my years as an investor. And yet, when I was two-thirds of the way through writing my latest book, a question occurred to me that I hadn’t considered before: why do we have cycles?
After reflecting on this question for a while, I came to what I consider the explanation: excesses and corrections. If the stock market were a machine, it would be reasonable to expect it to work consistently over time. Instead, the substantial influence of psychology on investor decision-making largely explains market gyrations.
Everyone knows, or should know, that parabolic stock market advances are often followed by 20 to 50 percent declines. However, those advances occur and are repeated, instigated by the voluntary suspension of disbelief.
Bull markets are, by definition, characterized by exuberance, confidence, gullibility, and a willingness to pay high prices for assets, all at levels that, with hindsight, appear excessive. History has generally shown the importance of keeping these things in moderation. For that reason, the intellectual or emotional justification for a bull market is often based on something new that history cannot rule out.
Consider the FAAMGs (Facebook, Apple, Amazon, Microsoft, and Google), which have a level of market dominance and scalability never seen before.
The dramatic performance of the FAAMG in 2020 attracted the attention of investors and supported a general turn towards optimism. By September 2020, these shares had nearly doubled from their March lows and are up 61 percent since the start of the year. Notably, these five stocks are heavily weighted in the S&P 500, so their performance resulted in a good overall gain for the index, but this distracted from the much less impressive performance of the other 495 stocks.
Or consider cryptocurrency. Bitcoin has been around for 14 years, but has been in most people’s consciousness for only about five. It fits economist John Kenneth Galbraith’s skeptical description of the kind of financial innovation in bull markets that older generations supposedly “don’t have the insight to appreciate.” Bitcoin enjoyed a dramatic rise in price from $5,000 in 2020 to a high of $68,000 in 2021, before falling this year to around $24,000.
The surprising performance of cryptocurrencies and “super stocks”, as well as technology stocks in general, in the last two years added to the general optimism of investors, allowing them to ignore concerns about the persistence of the pandemic and other risks.
It is risk aversion and fear of losing that keeps the markets safe and sane. But when bull markets heat up, caution, selectivity, and discipline often disappear. Optimism tends to exaggerate the merits of bull market winners. This pushes security prices to levels that are excessive and therefore vulnerable, because the swing to the upside doesn’t last forever.
We often see negative fundamental developments build up for a long time, with no reaction from security prices. But then a tipping point is reached, be it fundamental or psychological, and the whole heap is suddenly reflected in prices, sometimes in excess. And the stocks that have risen the most in bull years often experience the biggest declines in low years.
Some people may believe that asset prices are about fundamentals, but this is certainly not the case. If market prices are set by consensus of smart investors based on fundamentals, then why have many previously high-flying technology/digital/innovation stocks dropped by such large percentages in recent months? Do you really think that the value of many companies more than halved in this short period?
The price of an asset is based on the fundamentals and how people view those fundamentals. So the change in the price of an asset is based on a change in fundamentals and/or a change in how people view those fundamentals. Attitudes toward fundamentals are psychological/emotional, not subject to analysis or prediction, and capable of changing much faster and more dramatically than fundamentals themselves.
None of the market trends I have discussed relate exclusively to fundamental developments. Rather, its causes are largely psychological, and it is unlikely to change the way psychology works. That is why I am sure that as long as humans are involved in the investment process, we will see these trends repeat themselves over and over again.