The Pendulum Swings from Irrational Optimism to Brooding Pessimism

We have now come to a stage in the economic cycle which can best be described as "unbridled pessimism", if such a term actually exists. A few investing blogs such as Jeflin's have written about such events and how it has translated into pervasive fear in the stock markets. One would recall that not too long ago (perhaps just more than a year back), pundits and commentators were extremely positive about the global outlook and were thumping themselves on the back for predicting "explosive global growth". The same bunch of people are now falling over themselves to proclaim, in no uncertain terms, that we are in the worst financial crisis to befall us since the Great Depression. Not exactly a case of being very accurate and mystical, considering their lack of forecasting skill. But I will elaborate on the mechanism of pendulum swings and how it applies to capitalistic economies.

As readers may know, a pendulum is a device which swings from one extreme (left) to the other extreme (right) and back again to left. This is known as one wavelength in physics and the swing of a pendulum can be likened to one complete revolution. Applying this to economies, one extreme of the pendulum would signify irrational optimism about the economy's future prospects - the belief that economies in capitalistic nations will continue to grow without stopping at a steady, constant rate. This view necessarily espouses the theory that excesses which are built into the system will be "flushed out" naturally by the process of competition and that equilibrium will be achieved in a smooth, sustained manner. However, from what has been observed in past boom/bust cycles and if you include the current sub-prime mess, it is rather apparent that excesses in a system do not automatically clean themselves out in a tidy way; but often leave a big mess and a substantial trail of devastation which knocks the economy out of whack for a short period of time. Take the dot.com bubble, Asian Financial Crisis and the LTCM debacle and you will notice a pattern emerging for such "catastrophic" events. They all started out with excesses and ended up with a bust so painful that the most of the world thought that the capitalistic world (as we know it) was coming to an end.

Somehow, this process has been rinsed and repeated yet again in our most recent episode of sub-prime; namely that another shock wave has rippled through the economy and caused the collapse of notable names like Bear Stearnes and (probably) Lehman Brothers. I would argue that in any capitalistic society, such booms and busts are a necessary part of "cleansing the system" of bubbles and exuberance. Hence, back to the pendulum analogy, we find that it will begin to swing rather precipitously from one extreme to the other extreme. This can take a very short span of time (as evidenced by previous boom to bust incidences) and in our case, took less than a year and a half (since June 2007) for the full effects of the sub-prime mess to seep into every aspect of the financial system.

So now that the pendulum has swung to extreme pessimism, the question is when will it swing back again, and how long will it take ? This question has probably been tackled to death by the financial media and every guru and pundit has some view on it; so I won't go into details and bore the readers out there. Instead, if I looked at this from a different perspective, I would say that as long as the excesses have been cleared (i.e. all write-downs and write-offs have been completed) and when confidence is again restored, the pendulum will then start to swing back to the left again towards optimism. The point to note is that human emotion and psychology is probably the hardest to accurately predict, and so the eventual recovery of the economy, of confidence and of the markets will probably be a slow, gradual healing of a deep wound rather than a quick "stitch" to seal the crack. I am more of the opinion that the pendulum will swing slowly from right to left and that it will not be in a hurry to accelerate - which implies that I believe in a long, protracted slump until confidence returns to the system.

Of course, my opinion is but an opinion, and does not matter much in the grand scheme of things. What matters most to the retail investor is how he processes the information at hand to make decisions which will help him to maximise his wealth, and to beat inflation (at the very least). By being invested in good companies which can weather the economic storm, one stands a chance of preserving his capital and earning a decent return on his investment. An investor should follow a disciplined approach of looking at companies to determine if they are suitable investments for the long-term, and temper this with knowledge about economic cycles and the boom/bust model. Only the fittest survive a storm, and only a consistent investor who can adapt to changing times will be able to churn up consistent returns over time.