Market Cycles Explained

We’ve all heard of market bubbles and many of us know someone who’s been caught in one. Although there are plenty of lessons to be learned from past bubbles, market participants still get sucked in each time a new one comes around. A bubble is only one part of an important phase in markets, so if you want to avoid being caught off guard, it is essential to know what the different phases are.

Market conditions

Over the past 100 years we have had our fair share of financial booms and recessions and presently people seem to have forgotten this and are solely focused on the now.

We have had a pretty steady bull market since 2009 and although we have had some adjustments along the way 2019 is expected to be another positive growth year. You may continually hear from the layman that “now’s not the time to invest”, “i am waiting for Brexit…” or one of my favourites “your money is better off in crypto currencies”….uh huh….!

However, the market always provides opportunities to buy high quality investments but one has to know how to make sense of the market cycles. It is useful to look at the interaction and differences between the economic and stock market cycles to understand the opportunities that are there and how the markets move year on year.

Markets are cyclical

Cycles are prevalent in all aspects of life; they range from the very short term, like the life cycle of a May fly, which only lives up to 36 hours, to the life cycle of a planet, which takes billions of years.

No matter what market you are referring to, all have similar characteristics and go through the same phases. All markets are cyclical. They go up, peak, go down and then bottom. When one cycle is finished, the next begins. The problem is that most investors and traders either fail to recognize that markets are cyclical or forget to expect the end of the current market phase. Another significant challenge is that, even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one. But an understanding of cycles is essential if you want to maximize investment or trading returns.

The expansions and contractions of the economy are measured, and announced in the headlines, by changes in Gross Domestic Product (GDP). The “economic cycle” is the long-term pattern of alternating periods of economic growth and decline. Growth periods are expansions of the economy or “booms,” When real GDP (or national output) is rising quickly. Periods of decline are contractions of the economy or when the growth of output is below its long run trend rate and is termed a  “recession,” similar to the conditions we experienced in 2009. The highest point of a boom is called a “peak”; the lowest point of a recession is called a “trough.”

Economic cycle theory

Economies do not grow in a straight line. Instead, economies just like the stock market, typically fluctuate between periods of strong growth and weak or negative growth, known as the economic cycle or business cycle. Why these economic fluctuations take place is a complex subject, which has inspired many economic theories.

One widely held economic cycle theory is based on the relationship between supply and demand, and economic activity. The theory suggests growth in economic activity causes demand and prices for goods and services to rise. As goods and services become expensive, demand falls and economic activity slows down. This, in turn, causes goods and services to become cheap again, which leads to a new phase of growth in economic activity.

Usually lasting eight to ten years, the economic cycle is carefully watched by investors because it provides important clues about how financial assets, including stocks, bonds and commodities, may perform. As the economy shifts from one phase to another in the cycle, investors’ opinions on what is a fair price to pay for financial assets change.

This is one of the reasons why financial markets fluctuate. Smart investors who recognize the different parts of a market cycle are more able to take advantage of them to profit. They are also less likely to get fooled into buying at the worst possible time.

Investment strategy

One common stock investment strategy used by investors is to try to time investments to match the economic cycle. This strategy is based on the belief that the stock market reflects the health of corporate profitability and the economy, so it will overperform when the economy is growing and underperform when the economy is contracting. While history tells us there is truth to this idea, it also shows us the relationship between the economic cycle and the stock market is not quite so simple.

As an investor, you may have noticed that stocks can reach a bottom and enter a new bull market long before the economy emerges from recession, or peak and enter a new bear market even while the economy is still rising. During the recession from 2007 to 2009 in the United States, the stock market bottomed and began recovering 8 months before the economy reported positive growth.

To understand why this happens, let’s look at how investors make decisions. When investors buy shares in a company, they are largely doing so because they believe they can sell the same shares at a higher price in the future for a profit. There may be any number of reasons why investors may think that the price of the shares will rise. For example, they may believe the current share price undervalues the company or that the company has excellent business prospects and will be worth more in the future, or that the dividends being declared by the business will rise.

Whatever the reason, if demand for the shares from investors is strong enough, the share price will rise and keep rising until investors believe the shares are too expensive or the company’s fundamentals have changed in a way that negatively affects investors’ expectations of the company’s prospects.

The important point to take from this example is that when investors make decisions to buy or sell shares, they are always looking to anticipate what will happen next. As a result, the stock market cycle usually leads the economic cycle, with the market usually peaking before the economy peaks, and bottoming before the economy bottoms.

Timing the market

This is why trying to time the stock market investments based on economic and financial news can be a poor strategy and I never recommend using the mainstream media to guide your investment decisions. Stocks usually begin a new uptrend while the news flow and market sentiment is still negative or begin a new downtrend while the news flow and market sentiment is still positive.

Of course the million dollar question is finding out when and how the market will turn this is always difficult, if not impossible, to tell in the present and only becomes clear in hindsight. For ordinary investors without the time to follow financial markets, the sensible approach to take is to invest by pound-cost averaging, which will help smooth out market fluctuations.

You can’t afford to waste time you have to be in it to win it!

One of Warren Buffet’s quotes highlights the problems with procrastinating very well – ‘Predicting rain doesn’t count, buildings arks does!

Contact Me Today for an initial informal chat to look at ways in which I might be able to assist you with your current financial position.

About the author

Colin MacGregor is an independent financial advisor with over 10 years experience in the advisory sector and  has been based in Prague, Czech Republic since 2009.