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Predicting market cycles: How to be less wrong

During the year 1720, shares of Great Britain’s South Sea Company (SSC) rose to 10 times their va...

During the year 1720, shares of Great Britain’s South Sea Company (SSC) rose to 10 times their value within a few months. This company was a public-private partnership that found a way to convert debt to equity.

Spoiler alert – it did not work.

The story goes like this: SSC sold shares and bought government debt / bonds. In return, it paid dividends from the interest earned on those bonds.

Buying debt created liquidity for private bondholders and reduced the total amount outstanding. In turn, this liquidity increased prices for bonds, now held by SSC.

With higher-priced bonds, the value of shares in SSC went up, too.

Early success led to Parliament and the King approving a conversion of £30 million of national debt to SSC shares in 1720. Naturally, to finance this conversion, they issued more shares. And as share price rose, the company could buy debt or bonds “cheaper”.

This valuation was both circular and self-reinforcing. The stock price went from £140 in January to almost £1,000 in June. By October, however, the price had plummeted back down to £200 and the South Sea Bubble burst.

Some of the brightest minds invested in this company, including Sir Isaac Newton. He earned large profits early and cashed in his position, claiming the SSC was a scam. Later, seeing gains continue, he couldn’t resist the fear of missing out (FOMO) and re-invested his fortune right before the crash.

If Isaac Newton couldn’t resist the FOMO, can you?

The market cycle pendulum

We humans are emotional creatures. Our emotions drive our decisions and we are rarely in a balanced state. Seeing large gains on GameStop, we want to join the Reddit group.

Seeing Tesla stock go up, we fear missing out and want to invest. After all, Elon Musk will take Tesla stock to the moon in a SpaceX rocket, right?

We are usually either euphoric or depressed about the future. This is what causes market cycles that swing from “underpriced” to “overpriced”, seldom pausing in the middle. Worst of all, in finance, history counts for so little.

Within a decade the last correction is all but forgotten and we are distracted anew by a swing in the pendulum. The South Sea Company bubble burst over 300 years ago, yet there is no shortage of recent examples:

– Real estate of the 1990s.

– Long Term Capital in 1998.

– Dotcom in the 2000s.

– Global Financial Crisis of 2008.

Where are we in the current market cycle?

Market cycles cause profit cycles. Profit cycles cause availability of credit. And availability of credit drives the economy up or down.

What’s fascinating is trying to determine where we are in the cycle right now. Are we starting a post-pandemic prosperity cycle – a repeat of The Roaring ’20s” Are we at the tail end of a long bull market on the cusp of a correction? Or are we somewhere in the middle?

Looking at history we cannot find a time exactly like today.

But, as Mark Twain is reputed to have said, “History doesn’t repeat itself, but it often rhymes”. Vaccines are here and with that comes optimism.

Consensus among top minds is that GDP will grow at a record pace. Growth and productivity will work to control inflation and life will be great again – much like the roaring ’20s.

On the other hand, we’re still in a pandemic with business capacity constrained and rising prices. Governments have printed trillions in their currencies in the last 12 months and inflation is a real risk. In fact, it may already be here. If central banks increase rates to control inflation, what will it do to the economy?

This analysis is even harder for real estate development. Development is time-consuming and the time delay makes it more complex. A project that begins in one cycle five years later could be in another.

Not only it would be great to know where we are in the cycle today, we need to think about the future cycle.

Should you listen to economists?

Economists like CIBC’s chief economist Benjamin Tal and David Rosenberg, president and chief economist and strategist of Rosenburg Research & Associates, make predictions but often disagree with each other. How does that help choose the right time to invest in real estate?

Rosenberg is a perma-bear on markets. He’s so articulate and good at instilling fear that it is easy to start fearing your own shadow. After all, wasn’t he the one who warned about the 2008 Global Financial Crisis?

And eventually he’ll be proven right again. When that happens, because economy works in cycles, he’ll be hailed as the one who made that call.

Unfortunately, such predictions lack precise timing. And being right about a correction but calling it too early is the same thing as being wrong. Worse yet, markets can be irrational for a long time and there is no telling when the pendulum will swing.

Benjamin Tal is more optimistic and has a soothing, comforting effect on his listeners. Who is right?

Predicting the future

So, can we predict the future? As it turns out, no. There are only two types of forecasters – those who don’t know and those who don’t know they don’t know.

The best we can do is to act according to the odds of being less wrong. One could write books on the subject of how to do that.

But if there was a formula that predicted market cycles, there would be no market cycles. Investors would never pay more or less for an asset than that formula’s value. By removing emotion and personal belief about the future we would never get a “deal” or overpay.

The method to get the odds on your side

Ask yourself:

– Is the economy booming or sluggish?

– Are the lenders generous on terms or stingy?

– Is the availability of credit abundant or tight?

– Are the interest rates low or high?

– Is the number of sellers few or many?

– Are the prices for assets high or low?

– Is the return-on-investment low or high?

The more left-hand-side words you choose as answers, like ‘booming’, ‘generous’ and abundant’, the more cautious you should be.

Instead of acting on emotion like FOMO or following predictions of economists, I recommend using your own analysis. Choose a method for your investments and stick with it.

Heed the lessons learned from Sir Isaac Newton – he was right the first time about the SSC.

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