The Pendulum Effect
The pendulum is an interesting scientific device designed to demonstrate the earth’s rotation. The most famous pendulum is of course Foucault’s Pendulum, which was first hung in Paris in 1851. The original Foucault pendulum captured the earth’s natural movement, gravity and momentum in a tidy experiment -- a 28 kilogram brass bob hanging from the ceiling of the Pantheon by a 67 meter wire. It was beautiful art and science, all in one. It provides a metaphor for us today as we look at the markets.
Markets are systems of pricing assets that have natural movements. These movements are based on supply and demand, both of which have many influences and forms. For example, when money is tight, if demand for money increases rates will go up. The converse is true today. Money is abundant and the demand for money, even though significant, has not stopped rates from trending lower. In Germany, you can invest in a government bond and will receive a negative return, -0.69% on the one year and -0.67% on the five year, as of today. I don’t think I will be recommending German bunds anytime soon.
Stock markets have natural movements too based on asset allocation models, computer algorithms, and my favorite – investor psychology - among other factors. Some influences counteract each other, while others can reinforce the effect of a certain factor. In the past, on some historically bad days in the markets we have seen bad turn to worse as negative influences created additional negative inputs resulting in a very dramatic behavioral response – panic. But I won’t go into great detail on these few, scary days that we all would like to forget. Yet you might want to make a mental note that we judge the pain of loss to be two times greater than the pleasure of gain, according to the behavioral finance gurus.
In my experience, stock markets swing back and forth between growth and value, or between theme-based investing and numbers-based analysis. A simple characterization might describe growth investors as looking for future benefits whereas value investors operate strictly on the past results of companies because the future is unpredictable. Today, growth investors have been rewarded nicely while value investors remain frustrated and out of favor. Growth has the momentum and this momentum is proving to be a powerful force.
The future or the past? Growth versus value? A good story or good numbers? Change agents or the status quo? Sounds like our political situation, if you ask me. But you know I won’t touch that with a ten foot pole.
I’ll offer some concluding observations: Markets are natural systems influenced in many ways, some of which can be predicted while others cannot. We must prepare for these natural movements using all the tools and tactics available. Diversification, hedging bets, and taking profits are all pieces of our strategic puzzle. Why? To avoid the unexpected causing irreparable damage to your financial well-being.
About ten years ago, Foucault’s Pendulum experienced just such an unexpected event. The 67
meter wire cable snapped and the 28 kilo bob crashed onto the marble floor. The shiny,
beautiful brass orb was irreparably damaged. Let’s avoid that type of pendulum effect.
Ralph McDevitt
July 24, 2019
