The real value to investors of cycle theories

There are countless theories claiming that society and markets move in a cyclical way. They can’t actually help you time the market with any precision, but they are still very valuable tools, says John Stepek.

The new issue of MoneyWeek magazine is out today.

I don’t normally alert you to this, but our main story is about the 18-year property cycle. This is a theory (a pretty compelling one) that boom and bust cycles are basically driven by the economics of land.

You’ll have to read the story to get a full explanation of that (subscribe now to get your first six issues of the mag free). You’ll also probably want to read it to understand why the cycle predicts another four to five years of rising house prices and bull market before it all comes crashing down again.

But I’m raising it because what I want to talk about today is cycles and the value of cyclical thinking in general.

There are all sorts of cycle theories, all of them compelling

The idea that society and markets move in big sweeping cycles and then smaller, fractal cycles, is a very compelling idea, partly because the theories ring true, and partly because they give us something we’d really like – a way to predict what might happen in the future.

As a result, there are many examples of cycle theories out there.

Some of the best known in economics and markets include Kondratieff (or Kondratiev) waves. These are named after the unfortunate young Soviet economist Nikolai Kondratieff who outlined long-term boom and bust cycles of about 40 to 60 years in length, consisting of different phases.

Stalin took against him, primarily because his work found that capitalism – while volatile in nature – was sustainable. Like most people who Stalin took against, Kondratieff ended up in a gulag and was executed.

Many other cycles derive from or make similar observations to Kondratieff’s. One influential (and again, fascinating) cycle theory in Silicon Valley for example, is Carlota Perez’s theory of technological revolutions.

This sketches out five key technological revolutions that define their eras, starting with the Industrial Revolution in Britain in the late 1700s and continuing to today, where we’re at the tail-end of the Information Revolution (Perez seems to think that the green tech revolution is coming next, which seems plausible).

Other cycles focus more on social and generational shifts. According to another popular book by William Strauss and Neil Howe, we’re in a “Fourth Turning” right now, which is driven by shifting attitudes from generation to generation – ie, roughly every 20-odd years.

A similar sort of take comes from the increasingly popular professor Peter Turchin, with his theory of “elite overproduction”, which gained a lot of attention during the recent populism panic years.

And of course, going back to markets, there’s the Frisby Flux, which may sound like a medieval ailment, but in fact tracks the fortunes of the pound sterling according to an eight-year cycle.

The value of cyclical thinking

Let’s be very clear here: cycles aren’t to be used for timing purposes, whatever sales pitch anyone tries to attach to them. They can all make very compelling claims, but those claims are often selective and dependent on how you see things.

One person’s political turmoil is another’s welcome change of policy. Technology certainly changes society and definitely shapes markets – but how do you put specific dates on it, or at least ones that are useful for investors? When did the internet era really begin?

And find me an older generation in history who hasn’t been baffled and mildly appalled by the generation a few below them – I know I am baffled and appalled now that I’m old, and I know I was both baffling and appalling when I was young (stop right there with the obvious joke).

If there was a reliable timing tool out there, we’d all use it, and as a result, it would stop being reliable (because we’d all be trying to pre-empt each other’s timing), and we’d be back to square one. So if you’re looking for a magic number that says: “buy here, sell there, retire in comfort”, I’m afraid you’re not going to get it.

That said, I still think that cycle theories are useful.

One big problem for investors (and human beings in general) is “recency bias”. We tend to expect today to be like yesterday, and tomorrow to be like today.

This is understandable. The past is the only guide we have to the future, and the reality is that most days in our lives do tend to be a bit like the day before. Also, we don’t like change much. So we don’t like thinking about it.

This is one reason why momentum strategies work well most of the time. If a stock is going up, then chances are it’ll keep going up.

This also explains why most of the time, when asked for their year-end forecasts for markets, analysts will just add about 7% to whatever the market started the year at.

As a result, this bias means that all else being equal, markets will tend to overweight the odds that tomorrow will be like today. In other words, the market tends to misprice the future, with a bias towards the status quo.

And this is why cyclical thinking is valuable. We may not know how things will change, or we may only have the vaguest idea of roughly when we might expect to see change.

But thinking cyclically reminds us that neither life nor markets move in straight lines. Change is a constant. Being aware of that means that you can ask yourself: “What might change here? What outcome is most heavily mispriced? What is the market too complacent about?”

And that increases your odds of being able to spot things that the market has missed, which if you’re an active investor, is your goal.

Anyway – make sure you get the latest issue of the magazine. It’s sure to make you think, even if you’re not a believer in another four years of bull market. You can subscribe here.

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