The Great Devaluation

16The Circle

Modern investment theory has been built on the idea of the pendulum. In his excellent book Mastering The Market Cycle, Howard Marks explains how all investments swing along a pendulum of value. Assets move from undervalued to fairly valued to overvalued and then swing back to where they began. When assets drop and are left for dead, and nobody wants to buy them, they are at maximum undervalued and are at the peak of one side of the pendulum. Investors who recognize this will buy these assets on the cheap. As the market bottoms out and becomes less volatile and prices begin to rise, investors become more comfortable and the buying continues. As the price continues higher the buying accelerates until prices hit “euphoric” levels on the opposite end of the pendulum, at which point savvy investors begin to take profits and sell, and prices slide back toward fair value. In a normal world the price will fluctuate over time along this pendulum of value.

The business cycle refers to the expansion and contraction of credit and how that movement impacts asset prices. As credit is loosened, financial assets rise in value, and vice versa when tightened. Historically, the direction of credit is the current that moves the waves of the business cycle. These ebbs and flows typically play out over 10-year spans. Warren Buffett famously said, “Our markets work in ten-year cycles, it's a shame we only have seven-year memories.”

Figure 16.1

Buffett might be onto something. Over ...