Mutability and Variation

Fortune is painted blind, with a muffler afore her eyes, to signify to you that she is blind; and she is painted also with a wheel to signify to you, which is the moral of it, that she is turning and inconstant, and mutability and variation; and her foot, look you, is fixed upon a spherical stone, which rolls and rolls and rolls.
WILLIAM SHAKESPEARE, Henry V

THE stock market is always in motion. Not just rising and falling during the day, but over the weeks and months, through up years and down years and over secular cycles lasting decades, the market heaves and collapses, seemingly rotating between triumph and defeat.

Conventional explanations
Why does the stock market do that? Conventional analysis looks for macroeconomic causes, such as changes in profit margins, interest rates, and the growth rate of the economy. But there’s a small problem with that. First of all, it’s easy to see that the market’s instability is far more pronounced than changes in output or interest rates.

Second, sometimes the market moves in sync with the fundamentals and sometimes it has a mind of its own. Sometimes the market falls when the fundamentals are positive, like in 1962. Other times the market continues to climb in the face of rising interest rates and extreme overvaluation, like in 1999.

For their part, the media link market movements to the news of the day. But reaction to news is not a plausible explanation even for short term trends, like those that last several days, let alone trends that span years.

The beat of the street
Later, I’ll get into the source of market extremes that observers don’t talk about very often. But for now, look at the cycles in the S&P 500 themselves, measured here over a forty-year span from 1950 to 1990.

These are annual returns. Typically, after a negative year, returns leap, peak and then subside, completing a full cycle every three to five years.
Sine Wave

What goes up, must come down. Click chart to enlarge.

In high school physics, they describe sinusoidal oscillation like this as the height of a point moving around a circle over time. As we move around the circle, our path traces out a wave form, each phase on the circle corresponding to a positive or negative, rising or falling wave pattern. A sine wave is strikingly similar to the actual annual returns of the stock market.

And so the market rides the wheel of fortune through an endless series of bull and bear cycles. Yes, some turning occurs on economic change. But the violence and sheer lunancy on exhibit at certain points of the cycle must have another, behavioural cause. In other words, if price is consensus, then extreme prices reflect extreme beliefs. At market peaks, the swarm believes good times will never end. In the basement, it believes bad times will never get better. In both cases investors are reacting to and exaggerating the market moves themselves, not the subtle wobble in fundamentals like GDP and interest rates.

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