A market that spirals far off-course is suffering from the Look Back Effect, when past performance distorts what investors expect.
LOST decades are nothing mysterious. They are only encounters with the right-hand side of a boom-bust cycle. That said, it doesn’t make them any less unpleasant or disheartening.
There have always been many pessimists whenever there have been many people whose income has diminished.
Even if the market recovers from its initial crisis quickly, the ensuing inability to sustain progress, the low returns, and the negative ethos kills the spirit of the equity investor. In extreme cases, a phenomenon called the Look Back Effect can propel a downward spiral, where valuations don’t recover, and continue to decline, for a decade or two.
The Look Back Effect works because the future is always uncertain. Uncertainty makes investors nervous, so they look back a few years — and they look to each other — to decide what to do. In good times, after several years of high returns, the Look Back Effect seems to tell investors that what goes up, must go up. Fear of missing out results in very high valuations.
In times of trouble, past performance is discouraging, embarrassing. Sellers look back and feel the need to cut their losses. Buyers look back and hesitate. A newfound value-consciousness emerges. In the absence of supportive fundamentals like dividends or free cash flow, or in wilful disregard of them, expectations can sink for a long time.
Three examples of popular disenchantment are shown here. Long term declines demonstrate how investors synchronize their beliefs with past performance. In this, professional money managers are as susceptible as the average investor. For a while, the Look Back Effect is self-fulfilling. When investors are reluctant to buy, the market falls of its own weight. But investors eventually work themselves into a position where they could not be more wrong.
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