The Myth of Financial Market Cycles
What do Ray Dalio, founder of the world's biggest hedge fund Bridgewater, Howard Marks, CEO of Oaktree Capital Management and Peter C. Oppenheimer, chief global equity strategist at Goldman Sachs, all have in common in addition to being well known, widely admired, highly intelligent and successful? Managing hundreds of billions of client assets, they all wrote books on market cycles and rely heavily on this concept to make investment decisions. And they all failed to predict the recent COVID-induced financial market downturn.
You can hardly blame them. Within a few weeks, the global pandemic hit the world economy with overwhelming force. Politicians all over the world sent people into Lockdowns, forcing the already diminished economic activity to a standstill. Central banks and governments reacted with massive money-printing, borrowing and spending, saving financial markets from a yearlong struggle and instead sending them to new highs. This chain of events was inherently unpredictable.
Nevertheless, the concept of market cycles failed to capture one of the most significant financial events the world has ever seen. Therefore, it's useless as a tool for decision making, right? Not so fast. Instead of accepting this simple conclusion, commentators, journalists, investors, consultants and investment bankers keep talking of market cycles as if they were a scientifically well established concept with predictive value. Dalio and Marks, among others, argue that the recent downturn wasn't part of a typical cycle and go on making predictions about the world based on their beloved model.
If your model of financial markets fails to capture the most significant financial downturn and subsequent upswing in history, maybe it isn't the right model. Maybe, history isn't cyclical. Maybe, nothing ever is. Phenomena that appear cyclical in nature may be better thought of as stochastic processes with constantly changing probabilities. In hindsight, they may well look cyclical. The stock market can only move in two directions. When something can only go up or down, it is hardly surprising that - looking back - it went up and down.
Concluding from this, however, that predictive value can be found in market cycles, is wrong. Its weaker form - that knowing where you are in a cycle helps you estimate probabilities of future price swings - is also wrong. The world is too complex for such oversimplified mechanistic explanations to work as advertised.
Despite many assurances to the contrary, I have yet to see evidence that relying on the concept of market cycles helps investors make better decisions. Vice versa, many investors that rely on this concept didn't take sufficient advantage of the many opportunities that presented themselves in March 2020 (and the decade before). It may be time to rethink one of our most beloved ideas.