Are you looking to invest in the stock market? What drives the stock market?
According to Howard Marks, the securities market cycle fluctuates per shifts in investor psychology that depend upon underlying foundational cycles. He argues that positive investor psychology drives bubbles in which securities become wildly overpriced, leading to crashes in which they become underpriced.
Below we’ll look at what makes prices go up or down in the market.
The Factors Behind the Stock Market
Initial upticks in foundational cycles—for example, a steady rebound in GDP or profits that slightly exceed projections—are what drive the stock market because a handful of investors begin to purchase securities. Over time, as more people become aware of these upticks, more investors purchase securities. At this point, greed and risk tolerance begin to infiltrate the market as investors expect prices to rise indefinitely.
(Shortform note: In The Most Important Thing, Marks clarifies that in addition to greed and risk tolerance, conformity can cause investors to unwittingly participate in bull markets (those whose prices are rising considerably). He writes that many investors mindlessly do whatever their fellow investors do, causing them to make irrational decisions whenever the consensus view is mistaken.)
According to Marks, these greedy, risk-tolerant investors drive prices further until they form a bubble—that is, a situation in which securities’ prices far outstrip their true value. The defining aspect of a bubble, he argues, is the emotionally driven belief that the market will only ever go up, regardless of its current pricing. In other words, bubbles represent the victory of speculative, emotional investing over collected, rational investing.
(Shortform note: In Irrational Exuberance, Robert Shiller explains that the strength of moral anchors—that is, the narratives that convince investors to keep their money invested rather than selling their stocks and cashing it—determines how long a bubble will last. For example, investors in 2024 might accept the narrative that the explosion of AI products like ChatGPT will cause tech stocks to grow unchecked until 2030, at which point they’ll begin to sell. So, unlike Marks, Shiller doesn’t think bubbles require investors to believe the market will always go up, but rather that it’ll go up for a certain amount of time.)
However, this bubble will eventually burst when a few rational investors begin to realize that securities are overpriced and sell them en masse, causing a crash—that is, a situation in which securities prices drop rapidly, making them dip below their true value. The defining feature of a crash, Marks relates, is the inverse of a bubble: In a crash, the emotionally charged belief that the market will only ever fall reigns supreme. Thus crashes and bubbles alike both require investors to stop acting rationally.
(Shortform note: In the most severe crashes, it can take decades for investors to regain faith in the markets and bring them back to pre-crash heights. For example, following the stock market crash of 1929, the Dow Jones Industrial Average didn’t return to its pre-1929 peak until 1954, 25 years later.)
The Probabilistic Market
Although Marks’s portrayal of the market cycle sounds straightforward, he clarifies that in reality, the situation is more complex. Rather than psychological cycles guaranteeing bubbles and crashes, Marks contends that psychological cycles make these bubbles and crashes much more likely. In other words, the securities market follows probabilistic rules rather than deterministic rules.
In practice, this means that greedy, risky investing doesn’t ensure that a bubble will form that eventually causes prices to plummet; it merely makes it more likely. Conversely, it also means that fearful, risk-averse investing after a crash doesn’t always precede a rise in security prices; it merely makes it more likely that securities will increase in price.
(Shortform note: Against Marks’s claim that the market is probabilistic—such that greedy markets are more likely to fall and fearful markets are more likely to rise—some economists embrace the random walk hypothesis. According to this hypothesis, securities’ prices change with no discernible pattern, much like an individual going on a random walk. Consequently, economists who accept this thesis deny that it’s possible to gain an edge on the stock market since nobody can know which direction the market is likely to move toward.)
