The writer is co-founder and co-chair of Oaktree Capital Management and author of ‘Mastering the Market Cycle: Getting the Odds on Your Side’
I’ve lived through (and been schooled by) several significant cycles during my years as an investor. And yet, when I was about two-thirds of the way through writing my last book, a question dawned on me that I hadn’t considered before: why do we have cycles?
After pondering this question for a while, I landed on what I consider the explanation: excesses and corrections. If the stock market were a machine, it might be reasonable to expect it to perform consistently over time. Instead, the substantial influence of psychology on investors’ decision-making largely explains the market’s gyrations.
Everyone knows — or should know — that parabolic stock market advances are generally followed by declines of 20-50 per cent. Yet those advances occur and recur, abetted by the willing suspension of disbelief.
Bull markets are, by definition, characterised by exuberance, confidence, credulousness, and a willingness to pay high prices for assets — all at levels that are shown in retrospect to have been excessive. History has generally shown the importance of keeping these things in moderation. For that reason, the intellectual or emotional rationale for a bull market is often based on something new that history can’t be used to discount.
Consider the FAAMGs (Facebook, Apple, Amazon, Microsoft and Google), which have a level of market dominance and ability to scale up that had never been seen before.
The dramatic performance of the FAAMGs in 2020 attracted the attention of investors and supported a widespread swing toward bullishness. By September 2020, these stocks had nearly doubled from their March lows and were up 61 per cent from the beginning 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 attention from the far less impressive performance of the other 495 stocks.
Or consider cryptocurrency. Bitcoin has been around for 14 years but it has been in most people’s consciousness for only about five. It fits economist John Kenneth Galbraith’s sceptical description of the type of financial innovation in bull markets that prior generations supposedly “do not have the insight to appreciate”. Bitcoin enjoyed a dramatic price spike from $5,000 in 2020 to a high of $68,000 in 2021, before falling back this year to about $24,000.
The striking performance of cryptocurrencies and “super stocks” — as well as tech shares generally — in the last two years had added to investors’ general optimism, enabling them to disregard worries concerning the persistence of the pandemic and other risks.
It’s risk aversion and the fear of loss that keep markets safe and sane. But when bull markets heat up, caution, selectivity and discipline often go out the window. Bullishness tends to exaggerate the merits of bull market winners. This pushes security prices to levels that are excessive and thus vulnerable — because the upward swing doesn’t last for ever.
We often see negative fundamental developments pile up for a good while, with no reaction on the part of security prices. But then a tipping point is reached — either fundamental or psychological — and the whole pile suddenly gets reflected in prices, sometimes to excess. And the stocks that rose the most in the up years often experience the greatest declines in the down years.
Some people may believe that asset prices are all about fundamentals, but that’s certainly not so. If market prices are set by a consensus of intelligent investors on the basis of fundamentals, then why are many formerly highflying tech/digital/innovation stocks down by such large percentages in recent months? Do you really believe the value of many businesses more than halved in this brief period?
The price of an asset is based on fundamentals and how people view those fundamentals. So the change in an asset price is based on a change in fundamentals and/or a change in how people view those fundamentals. Attitudes regarding fundamentals are psychological/emotional, not subject to analysis or prediction, and capable of changing much faster and more dramatically than the fundamentals themselves.
None of the market trends I’ve discussed relates exclusively to fundamental developments. Rather, their causes are largely psychological, and the way psychology works is unlikely to change. That’s why I’m sure that as long as humans are involved in the investment process, we’ll see these trends recur time and time again.