Investing Basics: Cyclical vs structural trends

Some trends in investing are cyclical (mean reverting) and some are structural (permanent). Distinguishing between the two is crucial for investors.

Cyclical trends mean-revert eventually, but can spend long periods at either extreme. The longer the departure from the mean, the more likely people are to think the trend is irreversible. This is why distinguishing cyclical from structural trends is often tricky.
 

Largely cyclical trends

 
Investor behaviour and emotions have always been cyclical.

Humans have a tendency to become over-excited or overly pessimistic. We tend not to spend much time in the middle of these extremes because we favour certainty and firm opinions over nuance. We can flip quickly between the two states, sometimes without warning, but more often in response to external factors or new narratives. Herd-like instincts mean departures from the mean tend to be self-reinforcing, so these emotions can last for years, but over time they tend to broadly balance out.

This has many implications.

Stock markets and individual shares will have a tendency to become over- or undervalued. Bubbles are, by definition, inevitable and will always burst eventually. Conversely, superb opportunities will be presented at times of excessive pessimism.
 

FOMO, greed and the desire to get rich quick – morphing into fear and panic once reality hits – have always been part of the human psyche

 
People will create narratives to explain why over-optimism or over-pessimism is justified. Examples of the former include tech stocks in the late 1990s (“we’re entering a new technological age”) and the 2000s commodity and emerging market boom (predicated mainly on China’s rapid expansion).

Currently, I see animal spirits rising and signs of froth in some areas, including a number of loss-making tech stocks with weak business models and little ability to defend against competition.

The frenzied buying by retail investors recently is another example and is nothing new. The nature of speculation changes, whether it’s the purchase of tulips in the mid-1600s (tulip mania) or loss-making businesses today, but human behaviour doesn’t.

Fear of missing out (FOMO), greed and the desire to get rich quick – morphing into fear and panic once reality hits – have always been part of the human psyche.

Business leaders are prone to the same bouts of over-optimism and over-pessimism. During good times, businesses tend to over-expand, increasing capital expenditure and engaging in mergers and acquisitions. In tougher times they sit on their hands and may even downsize their operations to free up cash.

These behaviours reinforce the cyclicality of certain industries, particularly capital-intensive ones like commodities, shipping and housebuilding, leading to wild swings in supply, often in response to fairly small changes in demand.

This means industries like these will always tend to have a large cyclical element to them. Shrewd investors can exploit such fluctuations but they must be aware of which stage of the cycle we’re in – market timing is crucial in these industries.
 

Largely structural trends

 
I tend to define structural trends as those that are almost certain to continue for as far as the eye can see. In reality, nothing is 100% guaranteed or lasts forever. But some structural trends are very powerful, meaning it would take something fairly extreme to stop them.

To me, certain things seem inevitable and are structural in nature. What I’m about to say may seem blindingly obvious, but that’s sort of the point. Any predictions about the future are fraught with danger, and there are no brownie points in investing for coming up with contrarian but wrong views. If I’m going to base my investment decisions on assumptions about the future, they better be right.
 

• The human desire to progress – technological progress and innovation has been a constant theme over the last few centuries and will very likely remain so. Incomes will continue to rise, especially in emerging markets. Poverty and illiteracy will continue to decline. Healthcare will continue to improve. The global population will continue to expand, at least for the next few decades. The road ahead will not be smooth – it never is – but this will create opportunities for economies, businesses and consumers. This is why I’m a long-term stock market bull.
• I think digital and card payments will continue to take share from cash for the foreseeable future. I see the level of automation within almost every industry rising. E-commerce will continue to gain share from bricks and mortar. Data will become more integral to the day-to-day decisions of businesses and consumers; so will risk management, particularly post pandemic. Sustainability initiatives will only grow in importance as environmental and climate issues gain traction. Lifespans will increase and populations will age. Some companies will lose out due to these trends, and others look exceptionally well placed to benefit. Investors should allocate their portfolios accordingly.
• Some companies will be structurally advantaged by avoiding the short-term, herd-like behaviour that characterises most other businesses. Management teams that deploy capital in a countercyclical manner and create cultures fostering long-term, independent thinking will be at an advantage, because these behaviours are so rare. The same applies to investors – the advantages gained by avoiding (or, more accurately, learning to manage) unhelpful human behaviours and emotions will likely always persist. There’s a temptation to think you have to do something clever to succeed as an investor; but I don’t think that’s right. The key is to avoid acts of stupidity, by maintaining a long-term view and equanimity in the face of wild swings in Mr Market’s emotions.

 
This article was originally published at theundercovermanager.com and by our friends at The Property Chronicle