More on market cycles
We have established that there is a relationship between what the economy does and what the stock market does. Often there is a timing lag, but they tend to work in unison – even if there is a gap in the reaction time.
For example, in 1986, the economy was struggling, but stocks will hitting all-time highs. Well, the stock market was discounting the fact that a recovery was on the cards, and was leading the economy. Discounting was covered earlier, but is essentially taking things into account now that may happen in the future… like anticipating that the economy will recover and the stock market will go up… so, the positivity about the future results in a move up in the stock market now, before the changes actually happen in the economy. Over time, the news if ‘fully discounted’ or ‘fully taken into account’. But there will be a new event or new news that the market anticipates that will affect the market.
This results in cycles over time. Times are good, getting better, peaking, getting bad, bad, getting worse, bottoming out, improving, good, etc. The cycle continues.
Here is one way of viewing this cycle:
This shows a smooth cycle, but in reality the size of the wave changes over time, and isn’t smooth at all. Understanding the cycle, and getting the timing right, is very important to successful longer-term investing.
Riding the Cycle…
The problem with any cycle is getting an idea of where you are at the moment.
So, let’s start at the top, with the peak or boom. That means good times – when it looks like all the big companies and business people are driving new sports cars, expanding factories, extravagant living and making big money from almost everything they touch, including the stock market. This can’t go on for too long as the reserves aren’t big enough and as with any cycle – “all good things come to an end”. This ‘era’ is typified by high interest rates and high inflation. The cost of money doesn’t seem to make a difference in this time of ‘wild abandon’. There is often also a shortage of goods and waiting periods, profits are increasing at high rates, staff are moving on easily to bugger and brighter things… and the stock market, is getting jittery and probably starting to go down.
What about the bottom, the trough?
When the situation turns from “recession” to “depression” we are likely to see some of the following happening around us.
News will start writing about huge numbers of retrenchments, the country “living beyond its means”, bankruptcies and stores shutting down or going into administration. You will hear warnings of the perilous state of the reserves, government loans and rates moving down. Imports fall significantly, while exports start to pick up a little. This starts the green shoots of an improvement in the balance of payments.
In businesses, we tend to push our debtors for the cash they owe us while keeping our creditors waiting as long as possible – creating cash or liquidity in the process. Since everyone is doing this in some way, we all have a fair bit of cash (avoiding borrowing), so the money supply increases while demand falls, so interest rates start to fall.
As we head into the trough, which feels like the darkest period, we start to see the dawn. When we compare the increasing dividend yield (from falling share prices) to the lower interest rates banks offer, we feel more inclined to invest in shares. This increased liquidity results in share prices starting to rise again. Also, most investors know that after the ‘really bad’ trough comes a recovery… and that means better dividends and better share prices, which the market starts discounting again.
At this stage, when we are hitting the bottom, interest rates tend to go right down, business profits are under severe pressure, bankruptcies rise, unemployment is very high, and we can expect a recovery to begin in the economy within about six months.
And so, the cycle continues, with the stock market leading the charge out of the trough…
