Originally published March 2021.
Some trends in investing are cyclical (mean reverting) and some are structural (permanent). Distinguishing between the two is crucial for investors.
Cyclical trends mean-revert eventually, but can spend long periods at either extreme. The longer the departure from the mean, the more likely people are to think the trend is irreversible. This is why distinguishing cyclical from structural trends is often tricky.
Largely cyclical trends
Investor behaviour and emotions have always been cyclical.
Humans have a tendency to become over-excited or overly pessimistic. We tend not to spend much time in the middle of these extremes because we favour certainty and firm opinions over nuance. We can flip quickly between the two states, sometimes without warning, but more often in response to external factors or new narratives. Herd-like instincts mean departures from the mean tend to be self-reinforcing, so these emotions can last for years, but over time they tend to broadly balance out.
This has many implications.
Stock markets and individual shares will have a tendency to become over- or undervalued. Bubbles are, by definition, inevitable and will always burst eventually. Conversely, superb opportunities will be presented at times of excessive pessimism.
People will create narratives to explain why over-optimism or over-pessimism is justified. Examples of the former include tech stocks in the late 1990s (“we’re entering a new technological age”) and the 2000s commodity and emerging market boom (predicated mainly on China’s rapid expansion).