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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 all sort of discussions. This includes investors’ efforts to understand the stock market.

You could sum up the investment version of the pendulum 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, pendulum 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.

How Successful Investors Get RICH

Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor.

How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.

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 pendulum theory 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.” It bears keeping those words in mind when evaluating pendulum theory.

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 Successful Investor rule welcomes skepticism, not pessimism

Downplay or avoid stocks in the broker/media limelight. That’s because these stocks tend to develop exaggerated investor expectations – especially those of inexperienced investors. When these stocks fail to live up to those expectations, declines can be steep. Broker and media attention tends to build investor optimism and push these stocks up to relatively high prices. If the market weakens or if they run into internal difficulties, these stocks can drop sharply, so it’s a good idea to limit your exposure to them.

Instead of focusing on stocks in the broker limelight, investors following our Successful Investor approach look for stocks with hidden or little-noticed assets.

These are assets that are easy to overlook, since their full value rarely appears on a company’s financial statements.

These assets include long-time real estate holdings that are worth much more than the balance-sheet value. Under-used brand names are another good example. Another key hidden asset — is research spending. Companies write off their research outlays in the year in which they spend the money, but benefits (if any) such as new or better products may only materialize years in the future.

Adopt a realistic sense of optimism:

To succeed as an investor, put matters in perspective. Despite wars, recessions and market setbacks, stock prices generally reach successively higher levels over long periods. You can’t foresee the next downturn. But you can buy high-quality investments gradually during your working years, sell them gradually in retirement, and reinvest your dividends along the way.

Pendulum Theory is often trotted out by market pessimists, but have you suffered a significant setback from being too optimistic?

This article was originally published in 2009 and is regularly updated.

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