Market Cycle Highs and Lows: Why They’re Important and How You Can Prepare For and Profit From Them, Part I
Published on October 1, 2020
Think about one thing in your life that makes you proud. Is it raising your children, marrying your partner or building your career or business? Did any of those accomplishments take the express train to success? Like most good stories, it’s not likely, so why do many investors think their best ideas will only go up in a straight line?
Investors with a little experience understand that there is an ebb and flow to all markets, and even society as a whole. We often call these ebbs and flows “cycles” when they revolve around certain constant themes, like the business/economic cycle, the election cycle, the credit cycle and the market cycle. These cycles all impact investments, and understanding how they work can help you invest more profitably over the long run. By aligning and adjusting your asset allocations to cycles you may be able to boost returns and reduce risk.
This post is not exhaustive. There are many services and individuals who devote their lives to understanding cycles. I hope to give you an overview, pique your interest and provide you additional resources to take the journey as far as you want to go. To make things more digestible, the article has been split into two posts.
In this first post we’ll cover:
- Important Cycles and Their Relationships
- Why You Should Care About These Cycles
- Cycle Signposts
In the second:
- Adapting to the Market Cycle
- Cycles in International Markets
- Additional Resources
Let’s get started.
Important Cycles and Their Relationships: The Market and the Business Cycles
The two most important cycles for an investor are the market and economic/business cycles. The economic and business cycles are often interchangeable, so I will use the term business cycle for consistency in these posts going forward. These cycles happen because people extrapolate recent trends into the future. If the economy has been growing and I’ve gotten a raise for the last three years, I can buy a house I currently cannot afford because I will be able to afford it in a couple years. Conversely, in the depth of a recession, people assume the economy will never grow again.
The business cycle relates to underlying economic activity and is primarily defined by GDP growth. The key phases are the expansion, peak, recession and trough. The business cycle is connected to cycles with similar characteristics including the credit, employment and inventory cycles.
Ray Dalo’s video “How the Economic Machine Works” is a great simplified explanation of the business cycle dynamics. I disagree with some points raised in the latter part of the video, but the description of the short term cycle at the beginning makes up for it.
The market cycle has the same phases as the business cycle except the measured activity is usually stock prices. The names for the different phases are:
- Bull market
- Market top
- Bear market
- Market bottom
The business and market cycles are interrelated in the following way. Since the market is a discounting mechanism for companies and the economy, it reflects expectations about the economy and, for this and other reasons, leads the business cycle. We’ll have more on this later.
Why You Should Care About Cycles
For those well-versed in traditional financial advice, this section may be a bit controversial. There are many financial advisors who will tell you that timing the market is a road to ruin, and, for the most part, they are right.
Most who try to time the market do so without the proper risk management in place. They buy and sell without rules or a plan and end up a slave to their emotions. To address this problem, traditional financial advisors recommend clients simply ignore the gyrations and buy and hold their investments because the market will go up in the long run.
I see two potential problems with this. First, as any therapist will tell you, ignoring your emotions is rarely the foundation of anything successful. Pretending the movements of the market do not exist and that you can suppress your reaction to them will increase the odds of doing something rash. Fortunately, there are a couple easy ways to address this.
Second, people’s spending habits are not a straight line. If you plan on paying for a wedding in a couple of years or buying a home, it doesn’t matter if stocks go up on average 5% every year over your lifetime, especially if they end up dropping as you approach your big ticket purchase. Having an understanding of market and economic cycles can inform decisions on how conservative one needs to be with savings and investment funds over shorter periods. All of these points are fundamentally timing decisions, which advisors generally discourage.
With the right rules in place, one can use the undulations in the market to one’s advantage over the short to medium term. Furthermore, and perhaps more importantly, there are cycles across different asset classes and countries that may move differently. By investing in such cycles in the right manner, one can decrease the correlation of the investments in a portfolio and increase the potential returns without increasing the overall risk.
Now that you know why cycles are important, how can you determine where we are in the market cycle? There are several qualitative and quantitative indicators one can use here. But first, let’s simplify the analysis.
When assessing the current location in the market cycle, the important thing is to determine the inflection points (peaks and troughs) where the direction in the cycle changes. If there’s a bull market, the concern should be when it ends and likewise with a bear market. Secondly and, more importantly, none of the indicators presented here are exact timing instruments.
Unfortunately, it’s just not that easy. They should serve merely as indicators that, when aggregated with each other, give you a probabilistic sense of how close one is to a top or bottom:
Length of time: How long has the current bull/bear market been going? Bear markets typically last 6-18 months while bull markets can last 3-5 years. This is generally a weaker indicator and especially difficult to swallow given that the current market dynamics have shattered these general rules (2020 has witnessed both the shortest time to a bear market and fastest time to a bull market).
CAPE Ratio: The Cyclically Adjusted Price to Earnings (CAPE) ratio is not a timing tool per se but is broadly predictive of longer term returns. The ratio is similar to a normal price to earnings multiple, but instead of the last 12 month’s earnings or estimated future earnings, the ratio uses an average of the company’s earnings over the last economic cycle or fixed timeframe, say five or 10 years. The extremes of the CAPE ratio beyond the normal ranges also typically coincide with the tops and bottoms of the market cycle.
ECRI: The Economic Cycle Research Institute (ECRI) has developed a series of proprietary indices to track the economic cycle with various relationships to the economic cycle (leading, coincident and lagging).
Credit and Money Supply Growth: Growth in debt as alluded to in Dalio’s video is a driver of the business cycle. An acceleration in the growth of debt typically markets the move into a peak of the market cycle, while declining credit and broad money supply usually market a recession. Remember the housing crisis and ninja loans?
Credit Spreads: There is a general view in the market that credit and bond investors are usually able to sense market turns before equity investors. As such, credit spreads widening after being relatively narrow for a long period of time is a possible sign of the top, while spreads contracting after being wide for a long period of time is a signal that the bottom is in.
PMI’s: The Purchasing Manager Indices (PMI) of various countries, the ISM in the USA and IHS PMI’s conducted with partners in various other countries attempt to gauge sentiment across services and manufacturing supply chains. The baseline reading is 50 while any readings above or below indicate expansion and contraction. These readings are sentiment-based and are therefore coincident at worst and leading at best in terms of the business cycle.
Copper Price: Many investors also look at basic industrial components like copper for an indication of the cycle. As copper is a major component of many products, a pick up in price caused by reduced inventories and higher demand after a recession can be an indicator of a pick up in economic activity.
Investor Sentiment: Intuitive but difficult to evaluate, investor sentiment drives market expectations. When people become optimistic, they drive stock prices higher, and when they are forlorn, they drive them lower. There are many surveys that attempt to capture this, but the principle lesson, as Warren Buffet says, is to be “fearful when others are greedy and greedy when others are fearful”.
Notice that unemployment and actual GDP growth are not factors included above, and that everything above is either a market price, a historical range of a certain ratio or a sentiment indicator. In his book, Anatomy of The Bear, Russell Napier studies the 1921, 1932, 1949 and 1982 market bottoms and concludes that market bottoms precede the worst of corporate earnings and economic activity. Experience from the 2000 or 2007 market tops show that the market tops before the economy as well. As a discounting mechanism, the market should behave this way, and you should not look to GDP or unemployment except as lagging confirmatory indicators.
Finally, Howard Marx, founder of Oaktree Capital, one of the largest investors in the world and a pioneer of distressed credit investing, wrote a book called Mastering the Market Cycle. This book goes into greater detail about the nature relationship of the cycles previously mentioned. He also provides a helpful questionnaire that allows you to do your own survey of market sentiment, which can provide additional insight in determining where you are in the cycle.
After the Dalio video, this is the next resource I recommend to better understand cycles and how to invest around them.
There is a lot to take in and explore here, so we’ll pause until the next post to let everything set in.
As always, please send any feedback or questions to firstname.lastname@example.org and I hope you found the information useful.
To your investing adventure,
The Castaway Capitalist
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