The Long Good Buy

1. Cycles Persist Despite Change

Despite all the political, economic and social changes that have occurred since the 1980s, and notwithstanding the extreme events and difficulty of predicting human sentiment and responses to conditions, there have been repeated patterns in economies and financial markets.

Enduring Patterns. Despite dramatic shifts in technology, politics, and economic conditions since the 1980s, financial markets continue to exhibit cyclical behavior. Crises, crashes, bull markets, and bubbles recur, demonstrating underlying patterns of human behavior and market dynamics. These cycles are not perfectly predictable, but understanding their phases and drivers can help investors assess risks and opportunities.

Human Element. The emotions of fear and greed, optimism and despair, and the power of crowd behavior contribute to the repetition of patterns in financial markets. Investors often fail to heed warning signals of overheating and excess, leading to speculative bubbles and subsequent corrections. Recognizing these psychological factors is crucial for navigating market cycles.

Adaptation is Key. While cycles persist, each one is unique, influenced by specific events and economic conditions. Structural changes in industries and economic factors can shift relationships between variables over time. Investors must adapt their strategies to changing conditions, recognizing both the enduring patterns and the unique characteristics of each cycle.

2. Long-Term Investing Rewards Patience

For equity investors in particular, history suggests that, if they can hold their investments for at least five years and, especially, if they can recognize the signs of bubbles and of inflection points in the cycle, they can benefit from the ‘long good buy’.

Time Horizon Matters. Equities offer higher long-term returns than bonds, but also come with greater short-term volatility. Over longer holding periods (5+ years), the risk of negative returns decreases significantly, making equities more attractive for patient investors. This long-term perspective allows investors to ride out market fluctuations and benefit from the compounding effect of returns.

Dividends Enhance Returns. Reinvesting dividends is a powerful strategy for long-term wealth creation. A significant portion of the total return from equities comes from reinvested dividends and the power of compounding. In some markets, such as Europe, dividends can account for an even larger share of total returns.

Active Management Edge. While long-term investing is generally beneficial, recognizing signs of bubbles and inflection points in the cycle can further enhance returns. Avoiding sharp corrections and participating in early stages of market recovery can significantly boost an investor's overall performance.

3. Equity Cycles Have Four Phases

The idea behind this book is not to present models that predict the future but rather to identify the signals and relationships between economic and financial cycles that tend to exist.

Phases of the Cycle. Equity markets tend to move in cycles, which can be divided into four distinct phases: despair, hope, growth, and optimism. Each phase is driven by different factors and offers varying returns. Understanding these phases can help investors anticipate market movements and adjust their strategies accordingly.

Despair and Hope. The despair phase is characterized by falling valuations and negative sentiment, while the hope phase sees a rebound driven by expectations of future profit growth. The hope phase typically offers the highest returns, as investors "prepay" for the expected recovery.

Growth and Optimism. The growth phase is marked by actual earnings growth, while the optimism phase sees valuations rise again as investors become increasingly confident. Recognizing these phases can help investors time their entry and exit points in the market.

4. Asset Allocation Shifts with the Cycle

Different assets tend to perform best at different times, and returns will depend on the risk tolerance of the investor.

Varying Asset Performance. Different asset classes perform differently across the economic cycle. In the later stages of a recession, defensive assets like gold and long-term bonds tend to outperform. As the cycle moves into recovery, equities typically rebound sharply.

Inflation's Impact. The relationship between assets and inflation is complex. High and rising inflation is generally negative for both equities and bonds. However, rising inflation from low levels can be positive for equities, signaling the end of a recession.

Diversification Benefits. Diversifying across asset classes can help reduce risk and enhance returns over time. Combining equities with government bonds, for example, can provide a balanced portfolio that performs well in various economic conditions.

5. Investment Styles Rotate Cyclically

Although knowing where we are in a cycle in real time is difficult, and forecasting near-term returns is complex, there is useful information that investors can look at to help assess the risks and understand the probabilities of outcomes.

Cyclical vs. Defensive. Cyclical companies, which are highly sensitive to economic cycles, tend to outperform during periods of economic expansion. Defensive companies, which are less sensitive to economic cycles, tend to outperform during periods of economic contraction.

Value vs. Growth. Value companies, which trade at lower valuations, tend to perform well when growth is accelerating and interest rates are rising. Growth companies, which trade at higher valuations, tend to perform well when growth is scarce and interest rates are low.

Style Rotation. Understanding the cyclical rotation of investment styles can help investors enhance their returns. By adjusting their portfolios to favor the styles that are expected to perform best in the current economic environment, investors can potentially outperform the market.

6. Bear Markets Vary in Nature and Severity

The emotions of fear and greed, of optimism and despair, and the power of crowd behaviour and consensus can transcend specific periods of time or events, supporting the tendency for patterns to be repeated in financial markets even under very different circumstances and conditions.

Cyclical, Event-Driven, Structural. Bear markets can be classified into three types: cyclical, event-driven, and structural. Cyclical bear markets are driven by rising interest rates and impending recessions. Event-driven bear markets are triggered by unexpected shocks. Structural bear markets are caused by the unwinding of imbalances and financial bubbles.

Severity and Duration. Structural bear markets are the most severe and long-lasting, with average declines of over 50% and recovery times of 8-10 years. Cyclical and event-driven bear markets are typically shorter and less severe. Recognizing the type of bear market can help investors assess the potential downside risk and recovery time.

Precursors to Bear Markets. Common features preceding bear markets include deteriorating growth momentum, policy tightening, and high valuations. Monitoring these factors can help investors anticipate potential market downturns and take appropriate action.

7. Bubbles Share Identifiable Characteristics

It is often when broader risks in the economy and financial market valuations become excessive that failure to predict turning points in cycles become most obvious.

Rapid Price Appreciation. Bubbles are characterized by a rapid and unsustainable increase in prices and valuations. This often leads to unrealistic expectations about future growth and returns.

"New Era" Beliefs. Bubbles are often fueled by a belief that "this time is different," with investors convinced that traditional valuation metrics no longer apply. This can lead to excessive risk-taking and a disregard for fundamental analysis.

Easy Credit and Innovation. Bubbles are often accompanied by easy credit conditions and financial innovation, which can amplify speculative activity. Deregulation and light-touch regulation can also contribute to the formation of bubbles.

8. Post-Crisis Cycle Sees Unconventional Trends

The unusual drivers of the return [since the financial crisis]: Lower inflation and interest rates; A downtrend in global growth expectations; The fall in unemployment and rise in employment; The rise in profit margins; Falling volatility of macro variables; The Rising Influence of Technology; The Extraordinary Gap between Growth and Value.

Weak Recovery, Strong Markets. The post-financial crisis cycle has been characterized by a weak economic recovery coupled with strong financial market performance. This divergence is partly due to aggressive monetary easing and quantitative easing, which have boosted asset valuations.

Shift in Profit Drivers. Valuation expansion and rising profit margins have played a larger role in driving returns than revenue growth. This reflects the impact of low interest rates and the increasing dominance of technology companies.

Unconventional Policy. Unconventional monetary policies, such as quantitative easing, have had a significant impact on asset prices. These policies have helped to stabilize financial markets and support economic recovery, but have also contributed to asset price inflation.

9. Low Rates Distort Valuation and Growth

Zero Rates and Equity Valuations; Zero Rates and Growth Expectations; Zero Rates: Backing Out Future Growth; Zero Rates and Demographics; Zero Rates and the Demand for Risk Assets.

Equity Risk Premium. The equity risk premium, or the extra return investors demand for holding equities over bonds, has been affected by zero or negative interest rates. Lower bond yields can increase uncertainty about future growth, leading to a higher required risk premium.

Implied Growth. Using a dividend discount model, it's possible to back out the implied growth rate that the market is expecting. In a zero-rate environment, this can reveal whether valuations are justified by future growth prospects.

Demographic Impact. Demographics, particularly aging populations, can also influence interest rates. Higher demand for safe assets from older populations can push bond yields down, further complicating the valuation picture.

10. Technology Reshapes Market Dynamics

Tech earnings outstripped those of the global market (world LTM earnings [01/01/2009 = 100]); MSCI World value versus growth.

Sector Dominance. The technology sector has become increasingly dominant in the equity market, driving a significant portion of overall returns. This reflects the growing importance of technology in the global economy and the ability of technology companies to generate strong profit growth.

Disruption and Adaptation. Technology has disrupted traditional industries, creating both opportunities and challenges for investors. While some companies have been displaced by new technologies, others have adapted and thrived.

Concentration of Power. The rise of technology has led to a concentration of market power in a few large companies. This raises questions about competition, regulation, and the sustainability of current market trends.

Last updated: February 23, 2025