Just like the seasons, financial markets go through cycles. By applying basic economic principles and portfolio strategies, you can capitalize on these big market movements. To either ride the wave or weather the storm. In general, each market cycle lasts about four to five years and within each cycle are usually six stages. During each stage certain asset classes outperform others. That’s why it is important to buy the right asset class at the right time. And to always hold a good mix which diversifies your risk. So what are the six stages of the market cycle and what should you do in each?
Let’s start with stage one which begins with the market contracting. This is a good time to buy bonds. As central banks will lower interest rates and expand the money supply to improve the economy thus boosting bond prices.
During the second stage as the market hits bottom you all want to buy more stocks especially in financials. You can buy them cheap and hold on to them as the market turns around as it did from 2003 to 2007. As the bull market progresses into stage three and the economy kicks into full gear. There will be an increased demand for raw materials. This will lead to inflation. Making it a good time to buy inflation sesnsitive products. Such as commodity tracking ETFs.
During the fourth stage as the bull market reaches the late stage you all want to reduce the bond holdings as they will be peaking.
In the fifth stage as the market hits its ceiling and stock prices are maxing out you should look to reduce your stock holdings. In favor of more commodity ETFs. For example when the stock market declined in the late 2007 stocks dropped significantly. But commodity has continued to climb. Meaning if you had swapped stocks for commodities when the market was peaking you would have avoided losses and made a profit. Even as the stock market weakened.
Finally, there’s the sixth stage of a cycle when the economy contracts and all asset classes begin to decline. This is a good time to acquire defensive stocks. Like public transportation and healthcare companies which are less affected during downturns.
Of course if you’re a long term stock investor you may not need to switch around asset classes as long as you’re able to stomach the big market corrections. You can take the buy and hold approach instead. And accumulate fundamentally strong stocks. And profit during stages three and four as the market expands so those are the basic principles of market cycles.
Above we have seen how the markets move in cycles but let’s see what are the factors that govern those movements.
There are many things but they can be grouped into two main categories. fundamental factors like monetary policy, balance of trade, and unemployment and behavioural forces like how people respond to these policies. These two factors are always playing off each other in a series of actions and reactions. Like a cause and effect loop. Now as an investor, the key is to focus on the sequence of events in the business cycle and identify clues to determine what’s coming next. In general the market goes through two phases; an expansion which is generally good and contraction which is generally bad.
During the early stages of expansion the recovery is driven primarily by fundamental factors as economies expand and trade. Employment picks up as central bank usually tighten their policies to keep inflation down which is good for stocks and bonds but not so good for commodities. These fundamental leads to a rise in stock prices which only encourage more people to jump into the market. It is good at first but as this greed and exuberance spreads stock prices eventually outpace their actual value. This leads to inflation which is marked by an increase in commodity prices.
To counteract these behavioural forces, central banks usually step in and increase interest rates which help curb the money supply and decrease inflation. This action signals that the expansion is ending. And stocks will soon beyond the decline. But it also means that the commodity-related products will be going up. If you are aware of these signals you all know that this a good time to switch from stocks to commodities. Then during the recession that follows behavioural forces will become stronger than ever. As more people realize that the stock market is declining fear and panic will spread forcing, even more, to sell of their shares.
During these periods savvy investors will reduce their stock portfolios. And wait for the market to turn around which they will because eventually, central banks will step in and cut interest rates to increase the money supply. These fundamental drivers will lead to a rise in stock prices making it a perfect time to jump back in the market and that starts the cycle all over again.
Now as an investor it is important to recognize these signals and never lose sight of the bigger picture. It is like Warren Buffett once said be fearful when others are greedy and greedy when others are fearful. So keep an eye on the fundamental and behavioral factors that move the market and always stay one step ahead of the game.