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Over the 25 years I’ve been investing in the stock market, I’ve gone through a fair share of market cycles. From the euphoric highs of the late 90s tech boom to the lows of the dot-com bubble, the Financial Crisis of 2008, and most recently the Covid-19 pandemic. In between there have been periods of market peaks and troughs with high and very low interest rates, wars, debt crisis, political division, and more. There are four basic phases to a market cycle. First you have Expansion (recovery / growth), then Peak (optimism / speculation), then Contraction (decline / fear), and finally Trough (extreme pessimism). The challenge is that while we can identify these phases in hindsight, predicting their exact timing and duration in real-time is nearly impossible. We don’t know how high the market can go during times of extreme optimism, or how low it will go during times of extreme pessimism. 

 

Through my many years in the stock market, some invaluable lessons have been learned and some investing principles have been forged. I thought I would provide a summary of some of the lessons that have been learned along the way to help you understand the mindset during these market cycles. The key? It boils down to having a thoughtful value oriented approach to investing, having the patience to see it through, and having the discipline to stick with it when the market is going against you.

 

Human Emotion

 

“In the short run the market is a voting machine, but in the long run it’s a weighing machine.” 

Ben Graham

 

The primary force behind the stock market’s short term fluctuation is the push pull between euphoria and panic. This causes markets to swing back and forth as it reacts to short term news. Throughout history we have seen moments where investors thought they couldn’t lose. The Roaring Twenties which culminated in the crash of 1929. The “Nifty Fifty” Bubble of the late 60s and early 70s where stocks reached incredibly high price to earnings ratios. Investors thought rising prices would go on forever until the bubble burst in the 1973-74 market crash. Like Mark Twain said “History doesn’t repeat itself, but it often rhymes.” The FOMO factor is a real thing in the stock market. As people see their friends and neighbors making money, they don’t want to be left out of the party so they go in. But inevitably everything reaches a price where people are not willing to pay more. As mentioned above, at some point the party ends and reason sets in, much to the pain of market participants. 

 

Ben Graham, the father of value investing, captured this phenomenon perfectly with his famous “Mr. Market.” Graham described Mr. Market as a manic-depressive business partner who, everyday, offers to buy and sell you shares of stocks at different prices based on his emotional state. One day he comes into the office very happy and optimistic about the future, he offers to buy shares from you at very high prices. Other days he comes in depressed and fearful about the future, he wants to sell you his shares at rock bottom prices. According to Ben Graham, the key is not to be guided by Mr. Market but to take advantage of his mood swings.

 

The most important lesson that I take with me in working my way through market cycles; like Warren Buffett has said, “Be fearful when others are greedy, and greedy when others are fearful.” By understanding that the stock market is made up of human emotion you understand that at times there is an overreaction, the reaction is just right, or an underreaction. So you may be asking, how do we know which one it is? That’s where the fundamental value investing principles help guide you in determining the difference between the price of something and its true value.

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Being A Thoughtful Contrarian

 

When you are making a transaction in the stock market you are taking action on your opinion. But there are always two sides to a transaction. There is a buyer, who believes the stock will go up in time (short term or long term), and there is a seller, who believes the stock will go down in time. If we follow Buffett’s principle about greed and fear, we are being contrarians. However, being a contrarian in the stock market is about much more than simply doing the opposite of the crowd. Why? Because the crowd might be right! Like I mentioned earlier, the stock market is made up of human emotion making decisions about the possibility of future outcomes. Information comes into the market on a daily basis and the market might overreact, underreact, or everything in between. It is our job as investors to determine what the reaction is and if it's at times warranted. Being a thoughtful contrarian means doing work to determine a security's true value. This requires having an above average understanding of a business and the effects of the news in the underlying economics of the business. 

 

A thoughtful contrarian doesn’t just buy a stock because it’s down or unpopular; they buy it only after deep analysis determines that the company’s story is different from the short term narrative. This requires implementing a value investing approach that looks at the company’s economics, competitive advantages, management team and overall market positioning. By implementing this approach, you are able to determine a company’s intrinsic value. If the news has pushed the price down that provides a margin of safety, then it might be an opportunity to go against the current popular negative narrative and buy the stock.

 

The lesson learned is that in order to have conviction behind your ideas and at times go against the crowd, you have to do your homework. Since every transaction in the stock market is a vote on the ultimate outcome of your investment, you have to feel confident you are right and the other person is wrong. This requires a deep understanding and deep conviction. Focus on the long term dynamics and ignore the short term noise.

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Patience

 

Patience is the secret sauce. This is what separates the good investors from the great ones. Patience in waiting for the right opportunity and not chasing trends. Patience in waiting for your investment thesis to play out, often in times when you see everyone else making money in get rich quick themes. The true payoff of a value investor comes when the “weighing machine” eventually materializes the true value of a company. In the long run a company’s stock price is a function of its fundamentals. This is the time when the market finally recognizes the fundamental elements of a business you saw all along. The market starts to recognize a company’s earnings power, its assets, and competitive positioning. Stock prices start to approach its intrinsic value. The problem is that we have no control over how long that will take. Sometimes it happens within a month and sometimes over a 3 to 5 year period. Without patience, many value investments would be prematurely abandoned. The disciplined waiting allows the investor to compound returns over time, avoiding costly mistakes or chasing trends. Constantly evaluating if the company’s sound economics are still in place, if management is making the right decisions, and if the company continues to expand its competitive advantages allowing it to earn high returns on invested capital. If all of these factors are in place, we are happy with our business and we do nothing. Embracing patience in value investing is a requirement. A commitment to a philosophy of owning great businesses that will compound over time providing great investing results. This is easy to understand, but for most people very hard to do. 

 

Conclusion

 

Stock market cycles are inevitable. They expose the weakness in speculative strategies that destroy value through the chasing of short term trends. For the disciplined investor, market cycles provide opportunities. Having a long-term perspective becomes an advantage at times of fear. Resisting the urge to invest in times of extreme optimism keeps you out of trouble by not investing when valuations are too high and provides the ammunition to invest when markets turn. This approach requires intellectual curiosity and self awareness. It requires a commitment to an approach grounded in reason and sound judgement. It is committing to a philosophy that recognizes the power of fundamental analysis over short term market sentiments. Most valuable of all, as we have seen from the best investors of all time, this approach not only provides safety of capital, but a long runway of outstanding returns. Our approach isn’t just a strategy but a commitment to a disciplined, rational philosophy that provides more clarity in a market full of uncertainty. 

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Opinions expressed here are not to be

taken as investment advice. Consult with

your own investment advisor. 

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