Where Does the Market Go from Here?
“Learning is more about getting the wrong answer, getting better information, and internalizing the right answer. Big mistakes create knowledge.”
“We have all the knowledge of humanity on our phone, but won’t integrate it, think, or reason.”
Don’t Know, Don’t Care.
We all wish we could be indifferent to market cycles. We know for sure market cycles will occur, we simply don’t know in which direction and then, once we’ve figured out a direction, we certainly don’t know for how long. As John Maynard Keynes has said, “things change slowly, then very quickly.”
The illusion that one can either predict or get ahead of cycles, and an even more illusory assumption is to be able to predict when they will end, is the cause of great frustration for most investors, and why most investors underperform the market.
Investment history has shown us that familiar themes recur, especially because they are driven by human behavior. As we have discussed previously, the market is not an algorithm, it is not a simple formula to be understood, and it is certainly not “efficient” in that it processes all data dispassionately and objectively and then makes appropriate decisions based on that data.
Emotions, Supply, and Demand
Markets are driven by human emotion, and it is human emotion combined with the supply and demand dynamic that determines the price. Therefore, pricing is independent of anyone’s perspective about “intrinsic value.” As discussed previously, there is no such thing as intrinsic value because everything is based on the price, price is based on supply and demand, and that dynamic is subject to abrupt changes based on the whims of small numbers, and sometimes exceptionally large numbers, of investors.
Market cycles have been extreme, ranging from a bullish cycle starting from pandemic-related lows of March 2020 driving valuations to dizzying heights. Then, reality set in, along with global supply chain interruptions, commodity and food shortages, and other unique events, such as Ukraine. We are now seeing inflation, continued global disruption, and the sobering effect of unrealistic technology industry projections.
But the basic point is the sum of all these factors still leads up to uncertainty. It is unclear what the market will do, and the most effective investment strategy is to be indifferent.
Uncertainty and Indifference
Indifference does not mean you do not participate. Indifference means that one should be prepared to profit whether the market resumes its bullish cycle, continues to cycle spiral downward, or we are in a moderate to flat phase with more extreme and frequent volatility centered around some reversion to the mean.
The lesson is that no one knows. It’s easy to look insightful for a short time. Consider the three-year run that ARKK had. It dramatically outperformed the market and then crashed down to earth, and its five-year performance ended up losing money. Sustainability means just that — the ability to survive. Up and down cycles will occur.
There is a significant difference between being an investor and being a business that invests. A business looks for a competitive advantage, but mostly, it looks to be sustainable — which means managing risk. Managing risk means understanding that there will be cycles and uncertainty and that those cycles will be mostly unpredictable. Preparing for these conditions is what distinguishes success.
Bulls and Bears
Bull or bear markets, while some statistical analysis may define them on some objective basis, are best described as excesses and corrections driven by human behavior and emotions. The stock market is not a dispassionate machine. It is influenced substantially by psychology and emotion and drives the extreme volatility we are experiencing today.
Excesses formulate when investor optimism takes over (“everything’s going to go up forever.”) therefore, price doesn’t seem to matter because when the market is experiencing excesses, there is always a “greater fool.” As we have seen with technology-driven valuations, profits, even those predicted five years out, cannot support the recent soaring valuations.
Reality is beginning to appear, and the market is correcting. Those overly optimistic projections are now seen as unrealistically optimistic. Some of the valuation silliness that pumped up the stocks beyond any reasonable assessment is now falling back toward a more appropriate valuation. But human emotion takes over again, and pessimism exceeds realism.
Corrections always overcorrect. As excessive discounts occur, the market reacts to these new “bargains” and prices can recover.
Excesses bring extended periods of above-average returns and then corrections bring extensive downside. There are other factors at work, and each case is specific to the conditions of the time, but the specifics are irrelevant. We simply know there will be some set of factors that will cause an emotional overreaction by the market participants and that will create excesses and corrections.
The appropriate investment strategy is to know this will occur, and profit from both movements. The inputs are less important, and predicting those inputs is almost impossible to do with any reasonable accuracy.
The Emotional Spirals
Excesses become excessive because when things are going well, investors conclude that things will continue to go well, or even better. Rising prices are seen as a positive sign. It doesn’t seem to matter what those price levels are, except that they will rise from where they are. When there is a general feeling of optimism and that things will only get better, perhaps it’s time to duck for cover.
More specifically, keep things in moderation.
History does repeat itself. When convex stock market price appreciation occurs, there is typically a drop of 20% to 40% afterward. This lesson needs to be learned repeatedly because bad memory is the first sign of a looming financial crisis. When the lessons and knowledge of the past are dismissed because “this time it’s different.” We know a couple of things for sure — it is not different, and disaster awaits.
Bright futures where success is still rare, especially in technology, translate into a general belief that everyone will succeed spectacularly, and thus we have the fuel for excesses that lead to a market bubble.
Overvalued technology stocks that are now coming back to earth are one example, and cryptocurrency, especially bitcoin, is another. We have seen this valuation cycle and currently, a correction or even a meltdown is ongoing. But technology stocks and cryptocurrency share the same characteristics, as best described by Galbraith, “a new and always supremely self-confident generation sees a brilliantly innovative discovery in the financial world and overvalues it spectacularly.”
Corrections are similar. Driven by human emotion and behavior, they stem from, what is best described as, “what the smart investor does in the beginning, the fool does in the end.” It is also this very fuel that overcorrects and leads to significant price drops, and then new investment opportunities, and the wise, start all over again.
I Don’t Care
The fundamental point is that the pendulum swings and will continue to swing. Smart people, dumb people, easily swayed people, and prudent and skeptical people all drive market behavior. A preferred strategy is to let them do their worst and profit from market cycles they create that we know will be more frequent and more extreme.
As an example, recent discussions on the same investments have ranged from “growth stocks will have decades of potential earnings increases” to “investing based on this future potential is far too risky and these prices are now unreasonable.” Another is “there is nothing wrong with companies that report losses because they are spending to scale their business.” to “why would anyone invest in an unprofitable company. They are simply burning cash.”
The Nonsense Continues
While these extremes are amusing to hear, they represent a general market “wisdom” that is driving continued market cyclicality. As the compression of the cycles reflects multiple media outlets and the shouting and screaming of talking heads, there may still be fundamental wisdom to a series of long-term strategies. But that is for the brave and the bold long-term holder. Success is rare, and it’s not you.
Flawless to Hopeless
Narratives change quickly. Things are going well, and then suddenly, they go horribly wrong. Negative reactions tend to be stronger and faster. The air goes out of the balloon a lot faster than it comes in, and things fall apart quickly.
Investors tend to be famous for getting things right once in a row. Over the last several years we have seen technology-based investors betting on “transformative” businesses that had little prospect of being competitive or transformative rise by astronomical amounts. They got that right…once. But twice? Not so much. These holdings have corrected to a loss. Well-known “innovation stocks” are down, on average, about 60% over the last 12 months, mostly year to date 2022.
What Have We Learned?
The lesson is that human behavior controls the markets. Optimism, pessimism, psychology, fear, conviction, and resignation all play a role in adding to volatility and uncertainty. The markets are driven by human behavior, and that will remain profoundly volatile.
Frequent and intense volatility is here to stay. Market movements really can’t be predicted unless they are at extremes when prices are at absurd highs or lows. But, picking the high or the low is a fool’s errand. Understanding and profiting from volatility, managing risk, and believing in a sustainable investment model is still the best strategy.