Investment Basics - Market Cycles
Updated: Jun 7, 2020
There are reasons assets rise and fall. If you don’t understand those reasons, picking assets is like throwing darts at a dartboard. It’s all a gamble. You need not take those kinds of risks. Indeed, it’s essential you understand the risks of trading and protect yourself by staying within your risk tolerance. As you learn about events and trends that move assets, you can become better prepared to invest wisely.
Market cycles and trends are used to help investors predict the market. They are easy to see looking back, but much harder to pinpoint as they occur.
What Causes a Market Cycle?
The expansion and contraction of business, earnings, inflation, stability, and politics all affect market cycles. Basic human emotions and behaviors create market trends. People swing between fear and greed, between focusing on the good news and worrying about the negative. Markets react to the pendulum-like swing.
Economic Cycle: The most generic of all cycles is the economic one. It’s divided into four parts:
Market bottom and full recession
Bull market and recovering economy
Market top when the curve levels out and there is high expectation but less production
Bear market with the economy falling toward a recession
Kinds of Market Cycles
The length of a cycle and its beginning and end point are especially hard to see as they are occurring. The trend is easier to determine as you look at charts and historical data.
A Bull Market is a series of up-trends. You see higher highs and higher lows.
A Bear Market is a down trend. It’s characterized by lower highs and lower lows.
A Reversion to the Mean is the natural tendency of securities to come back to the norm as shown on long term charts.
A Sideways market is when the price bounces up and down but stays within a channel. This may show up at any point in a cycle. In the middle of a trend, it’s called a consolidation.
Companies may gain high valuations in a bull market, or low ones in a bear market, but some schools of thought believe secular cycles revert to the dominant P/E ratio.
Different investments can be in different cycles at the same time. Often the sector consumer staples will be in an uptrend while the technology sector is in a downtrend. Or the financials may be trending up while commodities are trending down. Savvy investors capitalize on these trends by shifting their assets away from a down-trending sector and into an up-trending sector. But entering a trend too early or too late will reduce profits and can result in losses. Secular cycles can last decades.
Cyclical cycles range around four years and within each cycle there will be many temporary dips or reversals. It takes skill to know if these dips indicate a change in the cycle or are just variations of the same trend. Traders may buy and sell on these smaller changes. Short cycles include things like:
The January Effect
Sell in May and Go Away
Options expiration dates
Monthly reports on employment, inflation, and other data
Long term investors exercise patience and hold their course during the short reversals. Understanding the basics of technical analysis may help investors spot trends and places where the market is likely to change direction.
Traders who are worried that the trend might suddenly change sometimes may place puts, calls or invest in a Contract for Difference (CFD) as insurance against that change.