For a hundred years, the stock market has been ups and downs, and it has never stopped. Countless cycles have passed through the historical sky like bright shooting stars.
Why is there a “cycle”? Why do investors put so much energy into the ongoing battle against market volatility? Because their investment psychology is always influencing the direction of the market. As long as humans are involved in investing, we’ve seen them happen again and again.
In this latest memo titled “Bull Market Rhymes,” Oaktree Capital co-founder Howard Marks analyzes the regularity of the bull market cycle and points out that through investors Behavior can determine the current stage and get out of the market before it crashes.
Out of the pursuit of wealth dreams, investors will lack the appropriate fear in the bull market frenzy, and the emergence of this kind of frenzy indicates that the risk is approaching.
Investors must know when bull market psychology takes hold and maintain the necessary caution, Marks said. “Bull mentality” is not a compliment, it means mindless behavior and high risk tolerance, and investors should be worried, not encouraged:
It is risk aversion and the fear of loss that keeps the market safe and sane. Marks noted that asset prices depend on fundamentals and how people perceive those fundamentals. High returns in a bull market make people more confident that new things, low-probability events and optimistic outcomes will happen. When people are convinced of the value of these things, they tend to come to the conclusion that “stocks were never too expensive.” At this time, new entrants bought aggressively, and the stock market remained high. Prudence, selectivity and discipline disappear when they are most needed.
Marks also cites the current stock market conditions as an example:
On Wall Street today, news of a rate cut pushes the stock market higher, but then the expectation of inflation due to lower interest rates pushes the stock market down, and then the realization that a rate cut can stimulate a depressed economy pushes the stock market higher, and then , the stock market eventually fell amid fears that an overheating economy would lead to another rate hike. Max bluntly said that he believed in the enduring investment adage, so the greatest investor behavior should be “the wise begin, and the fool end.”
Below is the full text of the memo:
While I use a lot of aphorisms and quotes in my memos, only a few make it to my top list, and one of my favorites is Mark Twain’s quote:
History will not repeat itself, but it will repeat with a similar rhythm.
It is well documented that Mark Twain said the first four words in 1874, but there is no accurate evidence that he ever said the latter.
Over the years, many people have said similar things. In 1965, psychoanalyst Theodor Reik made the same point in an article titled “Out of reach”. He added a few more words of his own, and I think his formulation is the best:
The cycle is iterative, with ups and downs, but the process is basically the same, with little variation. Some people say that history repeats itself, but this may not be accurate, history just repeats with a similar rhythm.
The investment events of the past will not be repeated, but the main theme of the event will be repeated, especially related to investment behavior, which is exactly what I study.
Over the past two years, the cycle Reik writes about has had its ups and downs and caught the attention of the market. What strikes me in particular is the re-emergence of the typical style in investment behavior that will be the subject of this memo.
Let me state in advance that this memo does not predict the potential direction of the market. As an example, the market’s bullish behavior started when it hit a bottom in March 2020, but since then there have been serious problems and major corrections both inside the economy (inflation) and outside the economy (Russian-Ukrainian conflict). No one, including me, can know how these things combine to affect the future.
My purpose in writing this memo is simply to put recent events in historical context and uncover some implicit lessons. This is crucial because we have to go back 22 years ago, before the tech-media-telecom bubble burst in 2000, to see the beginning of the real bull market and the end of the bear market it caused. Many readers have not experienced the events of the time because they started investing late.
You might ask, “What were market returns like before the global financial crisis in 2008, 2009, and the pandemic in 2020?”
In my opinion, prior to both crises, the market was rising gradually, not going parabolic. The rise was not driven by mania, nor were stock prices pushed to crazy heights, and high stock prices were not the cause of either crisis. The 2008 and 2009 crises stemmed from the housing market and the emergence of subprime mortgage securitization, and the 2020 crash was the result of the Covid-19 pandemic and government shutdowns to contain it.
Regarding the aforementioned “true bull market”, my definition of it is not from Investopedia:
The price of an asset or security in a financial market continues to rise over a period of time. The market typically sees a 20% rally after a 20% decline in stock prices.
The first definition is too bland and fails to capture the core sentiment of investors in a bull market. The second definition is wrong, a bull market should not be defined by a percentage change in price. For me, it’s best described in terms of how it feels, the investor psychology behind it, and the investment behavior it engenders.
I started investing long before the bull and bear market numerical standards were set, and I thought such standards were meaningless. Does the S&P 500 drop 19.9% or 20.1% really matter? I still prefer the old-school definition of a bear market—nerve-racking.
Excess and Correction
My second book is Mastering the Market Cycle: Getting the Odds on Your Side. As we all know, I am a student of cycles and a believer in cycles. I have gone through several important cycles (and education) over the years as an investor.
I believe that knowing where we are in the market cycle can inform us of what comes next. But when I was two-thirds of the way through this book, I suddenly thought of a question I hadn’t considered before: Why are there cycles?
For example, since the S&P 500 index was born in 1957, the average annual return over the past 65 years is slightly more than 10%. Why can’t its return be 10% every year? Just to add to the question I raised in my July 2004 memo “The Doctrine of the Mean”, why did the S&P 500 return between 8% – 12% only 6 times during this period, why was it at 90% The performance in time is far from this?
After thinking about it for a while, I think it can be explained that there are “overs and corrections” in the market.
If you compare the stock market to a machine that you want to keep running steadily over time, it makes sense. However, I think that the significant influence of investor psychology on their decisions can go a long way to explaining the volatility in the market.
When investors start aggressively bullish, they tend to draw the following conclusions.
First, everything will always go up, and second, no matter how much they pay for an asset, others will buy it from them at a higher price (the “Greater Fool Theory”) because They are highly optimistic about the market:
The stock price will rise faster than the company’s profits, and the increase will be much higher than the fair value (excessive rise). Then the investment climate starts to disappoint, the folly of overpaying becomes apparent, and the share price falls to fair value (correction) before falling further below that price level. A fall in the stock price can further trigger pessimism in the market, which in turn causes the stock price to fall well below its value (excessive fall). Buying at the bottom will eventually push the depressed stock price back up to its fair value (correction).
Excessive upsides can result in above-average returns for a period of time, and excessive downsides can also result in below-average returns over a period of time. Of course, there may be other factors at play, but I think “overs and corrections” explain most things. During 2020-2021, we saw some excessive gains in the stock market, and now we see them being corrected.
In a bull market, a favorable environment will lead the stock price to rise and boost investor confidence, and this investment confidence will induce aggressive actions, which will then lead to further stock price increases, and then there will be a more optimistic investment mentality and continued risk-taking operations. .
This upward spiral is the essence of a bull market, and its upward trajectory seems unstoppable.
In the early days of the outbreak, we witnessed a classic asset price crash. The S&P 500 first hit an all-time high of 3,386 on February 19, 2020, before plunging by a third in just 34 days, before falling to 2,237 on March 23. However, with the joint efforts of various forces, the stock price rose sharply again:
Among them, the Federal Reserve lowered the federal funds rate to near zero and announced massive economic stimulus measures along with the Treasury Department. These actions have given investors confidence that state institutions will do whatever it takes to stabilize the economy. A rate cut significantly reduces the expected return on an investment, affecting its relative attractiveness. These factors combine to force investors to start taking risks that arise in the short term. Asset prices then rose: By the end of August of that year, the S&P 500 had recouped all its losses and rose past February highs. Big gains in FAAMG (Facebook, Amazon, Apple, Microsoft and Google), software stocks and other tech stocks drove the market higher. Ultimately, investors concluded that they could expect a sustained rally in the stock market, which was also in line with their conventional mindset in previous bull markets.
Like the last point above, the most important thing in bull market psychology is that most people think that the stock price rise is a positive signal for the future market, and many people start to become optimistic. Only a few people would suspect that this market is excessively rising, and its returns are dependent on future expectations, so the rise will not continue and the market will reverse.
This reminds me of another favorite adage I first learned about 50 years ago, “The Three Phases of a Bull Market”:
The first stage, when some visionaries start betting that a bull market may come;
The second stage, when most investors realize that a bull market is happening;
The third stage, when everyone thinks the bull market will go on forever.
Interestingly, even though the stock market quickly turned from a weak March 2020 bottom to a May boom, led by the Fed, skepticism was the most common investor psychology I saw during this period, they asked me The most questions are:
The environment is so bad, the epidemic is raging and the economy is stagnant, can the stock market still rise? It was hard to find optimists back then. Many investors became what my late father-in-law described as “handcuffed people”: they didn’t buy stocks because they wanted to, but because they had to because the cash returns were low. Once the stock market starts to rise, they chase higher prices out of fear of being left behind.
Therefore, the stock market rally appears to be the result of the Fed’s manipulation of capital markets, rather than good corporate earnings or investor optimism. It wasn’t until the end of 2020, after the S&P 500 rose 67.9% from its March bottom and 16.3% for the year, that investor psychology finally caught up with the soaring stock price.
The bull market rarely goes through the first stage, and the probability of going through the second stage is also very low. Many investors have changed from the deep despair at the end of March of that year to the extreme optimism later.
It’s a good reminder for the moment. While some themes of historical events do repeat themselves, it would be a big mistake to expect an exact repeat of history.
Reasons for optimism, super stocks and new things
In a frenzied bull market, investors can become hysterical. In extreme cases, their thoughts and actions deviate from reality. The premise here is that something must emerge that both stimulates investors’ imaginations and prevents them from thinking carefully.
So it’s worth noting that there’s always something going on in a bull market: new developments, new inventions, and reasons to push stocks higher.
Bull markets, by definition, are characterized by upward prosperity, increased confidence, gullibility, and investors’ willingness to pay high prices for assets, all of which in hindsight prove to be out of bounds. Historical experience shows that keeping these characteristics within reasonable limits is critical. For this reason, the rational or emotional reasons that can stimulate a bull market come from new things and cannot be explained by historical experience.
History has amply proven that when markets experience bullish behavior, stock valuations are pushed higher, and investors begin to embrace new things without hesitation, the consequences are often very painful.
Everyone knows (or should know) that after a parabolic rise in the stock market, it usually falls 20% – 50%. However, as I learned about “the willing suspension of disbelief” in my high school English class, the above behavior continues to recur among investors.
Here’s another of my favorite quotes: