Linear thinking is dangerous. It is the easiest form of reasoning, lying on the path of least resistance. The simpler the path, the more readily people will march along it. Linear arguments are easy to make, as they require the least amount of evidence — past data points with a straight line drawn through them. However, the larger the crowd that follows the wrong line of reasoning, the more people pile in, and the greater the consequences if they are proved wrong.
A lot of things in nature, and thus in investing, are not linear. A past trend may or may not persist into the future. Events don’t happen in a vacuum; they are observed, studied and capitalized on — which in the case of investing may preclude a company’s future from resembling its past. As I write this, I think of successful companies whose achievements attracted competition, which then marginalized them.
Some things are inherently nonlinear, their behavior reminiscent of a pendulum’s: The further they swing in one direction, the harder they’ll go in the opposite direction. It is very dangerous to default to linearity with such nonlinear phenomena, as the more confident we become in the swing (the more linearity we observe), the closer we are to the pendulum’s reversing course.
Price-earnings ratios often follow a pendulum behavior. If you look at high-quality dividend-paying stocks — the Coca-Colas and Procter & Gambles of the world — they are now changing hands at more than 20 times earnings. Their recent performance has driven linear thinkers to pile into them, expecting more of the same in the future. Don’t! These stocks were beneficiaries of a swing in the P/E pendulum as it went from low to average and then to above-average levels.
