Topic: How To Invest

Pendulum theory: An imperfect way of understanding the stock market

pendulum theory

The “pendulum theory” grew out of Sir Isaac Newton’s 17th-century studies of gravity and physics, particularly his second law of motion. Yet the theory turns up in discussions of all sorts of non-mechanical topics. This includes investors’ efforts at understanding the stock market.

You could sum up the investment version of the theory like this: stock prices alternate between periods of overvaluation and undervaluation; the degree and duration of each period of overvaluation is related to the degree and duration of the subsequent period of undervaluation, and vice versa.

In other words, the theory says that when stocks head downward after a period of overvaluation, they won’t stop at fair value. Instead, they’ll keep dropping until they hit lows that are in some sense as out-of-whack as previous highs, or close to it.


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Pendulum theory explains the past, not the future

Pendulum theory is a handy way to label the past, and it gives you a sense of how stock prices behave. But it’s useless for predicting the future or timing the market. That’s why it generally plays a small part in successful investing. If you qualify as a “successful investor,” you probably recognize that the market never gets so high that it can’t go higher, nor so low that it can’t drop some more. This is a key part of understanding the stock market.

Pessimists use pendulum theory to back up gloomy forecasts

Today’s top pessimists lean on the pendulum theory, plus a narrow selection of downbeat statistics, to support their views.

When listening to pessimists, however, it pays to recall the words of Bernard Baruch (1870-1965). Baruch, one of history’s most successful investors, pointed out that the bearish or pessimistic market view always seems reasonable, even scientific, compared to the bullish or optimistic view.

The universe is constructed in such a way that nothing is certain. You can always come up with perfectly rational reasons why something won’t work. But people find ways to overcome obstacles, and some businesses succeed despite risks.

Sometimes it pays to be bearish. Other times it pays to be bullish. But as Baruch also said, “Don’t try to buy at the bottom or sell at the top. This can’t be done, except by liars.”


What is market timing theory? Should you use it?

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Our value investing approach offers a better way of understanding the stock market

Instead of trying to time the market, our value investing approach seeks to identify well-financed companies that are well-established in their businesses and have a history of earnings and dividends. These companies are likely to survive any economic setback that comes along, and thrive anew when prosperity returns, as it inevitably does. Making selections based on these criteria is the basis of our approach to managing the portfolios of our Successful Investor Wealth Management Inc. clients.

Two of the worst mistakes an investor can make are to plunge into the market when it’s close to a top, or to sell out near a market bottom. Both mistakes are easy to make, as most people learn as they come to be successful investors. Selling out near the bottom seems like today’s greater risk.

This article was originally posted on July 29, 2009 and has been updated.

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