Where do market cycles come from? The point is inflated estimates and corrections. If the stock market were a machine, one would expect it to perform stably over time. Instead, market fluctuations are largely explained by the influence of psychology on investor decision making.
Everyone knows – or should know – that a parabolic rise in the stock market is usually followed by a decline of 20-50%. And yet it happens and repeats over and over again because of the voluntary belief in the unbelievable.
Bull markets, by definition, are characterized by excess, confidence, trust, and a willingness to pay big bucks for assets—all of which, it turns out, are overpriced. As history shows, moderation is important. Therefore, the intellectual or emotional rationale for a bull market often depends on something new that cannot be explained in terms of history.
Take, for example, FAAMG stocks (Facebook, Apple, Amazon, Microsoft and Google), which have achieved record levels of market dominance and scalability.
The FAAMG’s sensational performance in 2020 attracted investors and propped up a massive bull run. By September 2020, these stocks have nearly doubled from their March lows and are up 61% year-to-date. Notably, these five stocks carry a lot of weight in the S&P 500, so their performance led to significant overall gains in the index, but it detracted from the much less impressive performance of the other 495 stocks.
Or look at cryptocurrencies. Bitcoin is already 14 years old, but in the minds of most people, it has only existed for about five years. This fits in with the skeptical description that economist John Kenneth Galbraith gave of financial innovation in bull markets that previous generations were supposedly “incapable of appreciating.” Bitcoin skyrocketed from $5,000 in 2020 to a high of $68,000 in 2021 before falling again to around $24,000 this year.
The astounding performance of cryptocurrencies and “superstocks,” as well as technology stocks in general, over the past two years has increased the optimism of investors who have begun to ignore fears about the pandemic and other risks.
It is risk aversion and fear of loss that keep the markets safe and rational. But when bull markets heat up, discretion, selectivity, and discipline often fizzle out. Bulls tend to exaggerate bull market winners. This pushes securities to excessive and therefore vulnerable levels as the rally does not last forever.
You can often see how negative fundamentals accumulate over a long period of time, while securities do not react to this in any way. But then comes a tipping point – fundamental or psychological – and all of this suddenly affects prices, sometimes too much. And the stocks that have risen the most during the upswing often underperform during the down years.
Some people think that the value of assets depends only on fundamental factors, but this is not true. If market prices are set by the consensus of smart investors based on fundamentals, why have so many stocks highly valued in the technology/digital/innovation space have fallen so much in recent months? Does anyone really believe that the value of many companies has more than halved in value in this short period?
The value of an asset depends on the fundamentals as well as how people perceive them. Accordingly, a change in the value of an asset depends on a change in fundamental indicators and / or a change in how people perceive these fundamental indicators. The attitude towards fundamental indicators is of a psychological/emotional nature, cannot be analyzed or predicted, and can change much faster and stronger than the fundamental indicators themselves.
None of the market trends discussed are related to fundamental changes alone. The reasons are probably more psychological, and the way psychology works is unlikely to change. Therefore, as long as people participate in the investment process, these trends will repeat again and again.
Prepared by Profinance.ru based on The Financial Times
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