Edward Quince's Wisdom Bites: The Marks Series - The Market Pendulum: Mastering Cycles and Extremes

Edward Quince (EQ): Howard, welcome. My blog often laments the financial world's short memory. When you look across history, what principle about the markets seems most dependable, and yet most consistently ignored by investors?

Howard Marks (HM): It is simply the inevitability of cycles. The mood swings of the securities markets consistently resemble the movement of a pendulum. While the midpoint of the arc best describes the location of the pendulum "on average," it spends very little time there. Instead, it is almost always swinging toward or away from the extremes of its arc, moving between euphoria and depression, or between celebrating positives and obsessing over negatives.

EQ: That sounds intuitive, yet we constantly see people caught off guard. If cycles are so reliable, why do investors repeatedly fail to heed them?

HM: The error stems from an excessive proclivity to believe the positives—and disregard the negatives—prompted by the desire to make money. This leads to the most dangerous phrase in investing: “This time is different”. This phrase is a recurring bull-market cliché that always bears scrutiny. The greatest mistakes regarding the economic cycle result from a willingness to believe that it will not recur. Although history does not repeat itself exactly, it "does rhyme" because of the tendency of investors to forget lessons and repeat behavior.

EQ: So, the extremes of investor psychology are really the primary driver?

HM: Absolutely. Patterns in investor behavior rhyme from cycle to cycle, creating profound opportunities at the extremes. When attitudes of euphoria are widespread, prices assume the best and incorporate no fear, which is a formula for disaster. Conversely, when others are frightened and pull back, their behavior makes bargains plentiful, signaling an opportunity to be aggressive. Importantly, the movement toward the extreme itself supplies the energy for the swing back toward the midpoint.

EQ: Given that we cannot predict when the pendulum will reverse, how should a thoughtful investor approach market conditions informed by cyclical extremes?

HM: While we may never know where we’re going, we’d better have a good idea where we are. The circumstances must inform our behavior. Emotion must be resisted. I find myself using one quote more often than any other: "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs". This means leaning away from the direction chosen by most others—selling when they’re euphoric, and buying when they’re afraid.

The Edward Quince Takeaway

Recognize that markets are rarely in the “happy medium,” but rather constantly oscillating between emotional extremes. Your goal is not to predict the next swing, but to be acutely aware of investor psychology—the more complacent and euphoric the crowd is, the more caution and prudence you must exhibit in your own actions.