Dear investors,
In a memo written in 1991 by Howard Marks, the famous fundamentalist investor at the head of Oaktree Capital Management, the movement of a pendulum is used as an analogy to describe the dynamics of market fluctuations. This pendulum movement idea would be revisited several times by him (in other memos and in the books The Most Important Thing and Mastering the Market Cycle) and pointed out as one of the most fundamental concepts to understand the behavior of markets.
At the negative extreme, when the general sentiment is pessimistic and prices reach their historic lows, it is as if the pendulum were at the 9 o'clock position on a clock. At the opposite extreme, when the climate is one of generalized optimism and it seems that nothing can go wrong, it is as if the pendulum were at the 3 o'clock position on the clock. The low point at 6 am is where price levels would have to remain if markets were always rational and measured. However, in the same way as the pendulum, the market spends less time at 6 am than in the lateral zones, with prices above or below what the most weighted evaluations point out.
It seems counterintuitive to say that a market made up of intelligent and qualified investors spends most of the time with distorted notions about the real value of assets, but rationality in markets is like the force of gravity acting on the pendulum. She always acts to bring her to the break-even point at 6:00. However, under the influence of an external force, this static equilibrium becomes dynamic: the pendulum oscillates around its equilibrium point, but does not stop there. In the market, the external force that disturbs static equilibrium and creates this pendular dynamic is the nature of human psychology.
Application of the pendulum analogy
Imperfect as analogies often are, this one carries some important differences. The first is that the pendulum movement of the market is not regular and calculable like that of a physical pendulum. It is not possible to know how far the market will go and when it will reverse its movement. The second is that the market does not move in the same direction until it reaches its extreme points. There are a number of short-term reversals, with no consistent method for differentiating brief reversals from those that will prove to be turning points in longer-term trends. A more accurate analogy would be that of a pendulum made with a Styrofoam ball and exposed to winds blowing now in one direction, now in another, without following any predictable pattern.
Although this random component frustrates investors' eternal desire to predict the future of market prices, there are two practical useful conclusions that we can derive from this analogy. The first is the awareness that, sooner or later, the market will reverse the direction of its movement to pass its equilibrium point again. The second is that, knowing the symptoms that become visible at the extremes of the market's pendulum movement, it is possible to estimate, with some confidence, whether it is to the left or to the right of 6:00. Even if this information is inaccurate, as it is not possible to know whether the pendulum is at 3 am or 4 am, it is useful for indicating which direction the market is most likely to move in the long term. If it is towards 9 am, the greater chance is that it will rise again and, if it is closer to 3 am, it is more likely that it will fall again.
Since the cause of the pendulum movement is human psychology and it is useful to identify the symptoms that indicate which zone the pendulum's current position is in, the next step is to map how the psychology of a typical investor evolves through the phases of the movement.
From the negative extreme to the break-even point
The hallmarks of this phase are the predominance of fear of losing money, skepticism in the face of good news and credulity in the face of bad news, leading to an aversion to investments that carry some risk. As a result, stock prices plummet and pessimistic narratives gain ground in public statements. Each further drop is further reinforcement that the bears are right and those who remain invested are labeled naive for not seeing the clear downtrend.
The psychological factor present in this phase is not only the fear of losses, but also the fear of going against what “everyone is seeing”, making mistakes alone and suffering the torment of having made such an “obvious” mistake. Most people prefer to follow the prevailing trend, under the psychological comfort that making mistakes with the rest of the market is an “honest mistake”, which always ends up justified by something so unpredictable that no one was able to predict it, while making mistakes alone would be a mistake. foolishness, an unacceptable mistake that no one else has committed.
This tide of pessimism is only reversed when prices reach levels so low that the asymmetry between potential return and risk begins to draw attention and inject confidence in the most rational investors. The fear of making a mistake alone is replaced by the hope of getting it right alone, which would carry not only the laurels of having seen what no one else was capable of, but huge profits. So, some of these investors enter the public discussion as challengers of the pessimistic theses, defending that the market has gone too far and the trend will reverse.
As exaggerated theses for either direction tend not to materialize, when market sentiment is at an extreme the passage of time benefits those who go against common opinion. As the catastrophes prophesied by the most enthusiastic pessimists do not happen and the economy presents better results than expected, sometimes due to the simple effect of reversal to historical average results, more investors begin to change their minds and return to investing in variable income , causing prices to rise again.
Taking as a starting point the undervalued position prices at 9:00 am, rational analyzes have room to justify an upward trend for a certain time, until the break-even point is reached at 6:00 am. During this movement, optimists gain space in the media and become the new opinion makers, imbued with credibility by the recent upward trend in prices.
From the break-even point to the positive extreme
Just as the physical pendulum reaches its maximum speed when it passes 6 am, the market arrives at that point in full swing and passes it without difficulty. As much as rationality was the force that caused the reversal of the downward movement, few investors long on the stock exchange will remain faithful to it and invert their optimistic discourse from the moment that their shares exceed the fair values calculated at the time of the extreme negative . Their financial interests are for prices to continue rising, so their public demonstrations will point in that direction.
Even for those who wanted to warn the market that the break-even point has been crossed, the rationale is still too weak to stop the bullish trend. Valuing variable income assets is an imprecise science, where margins of error of the order of 20% are common. Thus, saying that the markets are slightly overvalued is interpreted as a mere opinion based on unwarranted skepticism, at a time when the economic environment is favorable and the market mood is positive.
During the pendular movement towards 9:00 am, investors who are already long are encouraged to remain optimistic by the greed of continuing to earn money, while investors who are still outside the stock market are influenced by two feelings that are reinforced: the envy of those who invested before (and they made more money) and the fear of continuing outside and not making money along with the majority of the market. Again, it is the fear of making mistakes alone and not taking advantage of the “obvious” opportunity that everyone is taking advantage of, exposing themselves to ridicule.
As investors who were outside the stock give in to these sentiments and decide to buy, they create additional demand that encourages the continuation of the upward movement. Although it is no longer so rationally obvious that stocks are undervalued, they need to go up for new buyers to make money, so they also start to argue that there is still plenty of room for a price increase. Gradually, the concern with the risk to which businesses are naturally subject is being diluted.
At the positive extreme, at 3 am, risks are downplayed and the return required to accept them becomes unreasonable. Projections of long-term results now consider scenarios in which no negative event arises in the future. Several competing companies are projecting aggressive growth that could only be achieved by gaining market share from the others and, even so, they continue to be supported by confident shareholders willing to pay high valuations for their shares, underestimating the difficulty of competition. Thus, several “unicorns” appear, some of them reaching billionaire valuations without ever having generated profit in their existence, sustained purely by the optimism and faith of their investors.
The new price level is bound to be unsustainable. The passage of time gradually unmasks these overly optimistic theses, with company results frustrating market expectations and investors prone to taking too much risk, who tend to occupy the spotlight while the uptrend lasts, suffering large losses. Thus, more and more investors migrate to the side of the skeptics and sell their shares, starting a new downtrend.
Managers, advisors and individual investors
This psychological trajectory considers a lone investor, who only looks at his portfolio, at the economic data and operates directly in the market, but there is an extra degree of complexity in the real world. A small fraction of individual investors buy and sell stocks directly on the market. Most of them are assisted by advisors from brokerage houses or wealth management offices, who select fund managers who, in fact, operate directly on the stock exchange.
These financial market professionals are under slightly different conditions when compared to individual investors. While the latter can operate in secrecy and alone digest the bitterness of possible losses, professional managers and advisors have their opinions or their portfolios open to public scrutiny and depend on their reputation to maintain a good career trajectory, so the fear of going against the current and making mistakes alone is especially worrying, as it exposes them to the risks of ridicule by their peers, attacks by their competitors and loss of customers who come to doubt their competence after mistakes. Getting the timing of a trend reversal right is also a more sensitive topic for professionals. If they act too soon and go against the grain for too long, they can lose their customers before time proves them right, and winning them back is far from easy. This further intensifies the likelihood of the market moving farther away from breakeven, as many professional traders will hesitate before taking the lead in the trend reversal.
What Individual Investors Can Do
Individual investors own the money and thus have the final say on where their capital is allocated. Even if they do not operate directly on the stock exchange, they decide whether they want to have their capital invested in stocks by choosing to invest in stock funds or in other types of funds. Investors who hire wealth managers theoretically delegate this task of choosing asset classes and funds to their advisers, but not all of them give them complete freedom. When a client expresses his opinion about what should be done, the advisor has to choose between the audacity to contradict him, at the risk of losing the client if his recommendation is wrong, or just following the expressed opinion, under the protection of justifying who just did what the customer asked. With incentives designed this way, it's hard to judge those who choose the safest path for their own careers.
Ultimately, the individual investor remains responsible for important decisions. An alternative is to elect people you trust and really leave them free to design their investment strategies, an act that will require temperance to tolerate mistakes from time to time, since no investor will be infallible. Another possibility is to interact with your advisors and continue to participate in decisions, but be careful not to corner them, at the risk of suffering from the same illness as a boss who favors employees who always agree with their own opinions and ends up surrounded by sycophants without any initiative .
Another precaution is to track where your own opinions about the market came from. The theses that gain the most popularity are usually quite elegant and, therefore, it is common to consider them market insights, but an insight only has value before it is widely known by the public, as the saying “what the wise do at the beginning” reinforces , fools do in the end.” If your opinion was formed from news published in the mainstream media and most of the people you talk to agree with it, you are aligned with the prevailing market trend and the opinion is not an insight.
It is worth mentioning that not always the best thing to do is to go against the general trend. This depends on where the pendulum is now. Between 9 am and 6 am, while bullish is the rational direction the market should be moving, following the trend is the best strategy. The risk/return ratio becomes unfavorable in the zone between 6:00 am and 3:00 am, where continuing to follow the uptrend carries the risk of being long when the movement reverses and suffering reversal losses.
where are we today
Eliminating the wrong alternatives is always a good method to facilitate the diagnosis. Today we are clearly not at the positive end of the stock market. The hot topics are fixed income and investments abroad, the latter driven by a major commercial effort by some brokerage houses that recently launched the possibility for Brazilian investors to open accounts to invest in the United States. The market direction is also clearly in the direction of 3:00 am to 9:00 am (decreasing), it remains to be seen whether we are before or after 6:00 am, the break-even point where valuations would be close to their fair values.
The best approach to answering this question is a technical one: evaluating several companies and comparing our own fair value estimates to market prices. However, this approach is impractical for individual investors because of the amount of work involved in these assessments. The same concept could be applied comparing current valuation multiples with their historical averages, but the conclusions of this simplified method must be taken with great care, as multiples can vary sharply in certain situations.
A second approach to gleaning indications of where we are is to assess the psychological state of most investors. In the last 2 months, what we have noticed is a strong aversion to variable income. We've heard from a number of investors, including professional advisors, that it's not worth spending time evaluating investment opportunities in equities at this time, as the current return on fixed income is already sufficient. This a priori pessimism about stocks, without judging the merits of specific opportunities, is characteristic of the negative extremes of the pendulum swing.
The technical approach points to the same conclusion. Several of the companies we analyzed are priced substantially below what we estimate to be their fair value. Unfortunately, it is not possible to know if the pendulum is already very close to 9 am or if it is still passing by 8 am, but it seems safe to say that we are already past 6 am.
“Buy at the sound of cannons, sell at the sound of trumpets.”
– Nathan Rotschild
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