Stages of the market cycle
The market cycle is a broad concept that refers to trends in different markets. Basically, it covers a period of time within which the market shows similar patterns.
It is such a broad concept that it does not give a global picture at all. It also means that the length of a cycle varies from industry to industry, and that even at the same point in time, geographical areas may show different pictures.
As no two market cycles are the same, the subject is far deeper than can be covered in a single article. While the basic principles will appear everywhere, you will find differences. That is why we will look at the general structure here.
Of course, since we are talking about a cycle, there is a growth phase and a decline phase. You’ll see that when we talk about the growth phase, it doesn’t necessarily go hand in hand with the growth of all investment vehicles.
The whole cycle can be broken down into 6 distinct phases. Of course, you can also divide them into further sections. Given that we are talking about an iterative process, you may also encounter situations where the numbering will differ.
The first stage of the market cycle
The first stage starts after the trough is reached. This is when hope appears. People start buying, thinking that the worst is over. It is also the beginning of the expansion.
What happens at this stage of the cycle?
Low raw material prices
Production fell during the recession, so fewer raw materials were needed. Whatever is in low demand, its price goes down.
So at this stage the price of raw materials is down compared to other stages, it is easy to amass to meet the recovering demand.
Financial recovery
This will also have the financial backing for those who have survived the recession.
Governments and central banks will then focus on stimulating the economy. The most common sign of this is that the central bank cuts base rates.
A low base rate helps the recovery in several ways.
Bond and credit market recovery
The first is that since banks also price their own interest rates at the base rate, the low base rate makes commercial loans cheap. This means that companies say yes to more investments. The low interest burden also reduces the risk for banks, so they are more willing to lend.
However, there are also examples of firms needing more money than this, money that they can no longer get through more banks. They then issue bonds.
In the economy, you can see this in this market cycle
What you can see in the economy is that the price of commodities is persistently down. Investors care about what they get for their money, and with low base rates, they don’t pay much interest on government bonds. Many people don’t trust equities yet, so demand is also picking up for newly issued bonds or bonds already on the market.
GDP and other economic indicators are starting to improve as the credit boom channels more money into the economy. People are spending more, and sales and productivity are rising. This in turn has a positive effect on company performance, driving up share prices.
Choosing investment instruments
With what you can achieve good results
- consumer sector stocks: after all, people are keen to spend money in anticipation of the coming recovery
- luxury goods sector stocks: during the crisis, either there was no money or, if there was money, people were cautious and delayed purchases.
- the technology sector and the industrial and financial sectors: because businesses and their consumers need credit
- bonds
What’s not recommended: here you can make little profit even on commodity exchanges (or you have to think longer term, after all, if you buy the product, you have to store it)
The second stage of the market cycle
The second phase begins when the influx of new capital and growing opportunities fill people with optimism.
What happens at this stage of the cycle?
Prices are rising, investors are looking for new opportunities.
Decrease in central bank stimulus
As the economy continues to grow, further stimulus from central banks and governments is no longer necessary, so the base rate can start to rise.
Raising interest rates is also important to preserve the purchasing power of money, as rising prices inevitably go hand in hand with rising inflation. And one of the main tasks of central banks is to keep inflation in check.
Growth in lending and sales
This increase will reduce growth in interest-sensitive sectors. These are typically sectors that require a significant amount of investment, e.g. producing something. The information and technology sectors are not included here, they do not need large buildings or other large-scale investment to operate.
Growth continues at this stage. Lending continues to grow and with it sales. However, towards the end of the phase, the rate of growth appears to be declining. On the one hand, those who have bought are now using the product, not necessarily buying another one, and on the other hand, the credit taken out has a cost. So productivity and profits are slowly peaking.
In the economy, you can see this in this market cycle
What you see in the economy is that stocks in general are doing pretty well. Shares are outperforming bonds, but there’s still demand for them.
Unlike before, you’ll see that a lot of commodities are already being used at this stage, so the price of those is starting to move up.
Choosing investment instruments
The stock market performs well at this stage, as do the investments that are based on it. Bonds are now mostly recommended for lower risk and shorter time horizons.
The third stage of the market cycle
In the third phase, the slowdown is already beginning, but it is not yet a decline, only a slower growth.
What happens at this stage of the cycle?
Since many people have already taken the opportunity to buy, obviously fewer will buy. This is why industrial productivity and profit rates are falling. Loans are being made on tighter terms, which in itself is enough to reinforce the previous point.
The combined effect of all this is that GDP is growing more slowly.
In the economy, you can see this in this market cycle
The price of raw materials continues to rise in line with the price of shares. As borrowing has become more costly and the price of raw materials has risen, there is less potential for profit in equities, but there still is.
The same cannot be said for bonds, where demand is expected to fall. This is due to a number of things. The first reason is that the return outlook for equities is still higher than for bonds.
The second is the rise in interest rates already mentioned, which also affects the interest rate on newly issued bonds, and also affects the demand for bonds already in circulation because of the factors we have discussed in the discussion of duration.
Choosing investment instruments
Unlike the previous phase, it’s worth taking a closer look here.
There’s still demand for raw materials, but if you’re going in this direction, look carefully at who the buyers are. After all, if a sector can no longer afford to finance growth, it won’t need raw materials as much.
Although the performance of equities is still positive, as sales and productivity fall, their share price will no longer soar. You can only achieve profits similar to the previous stage at the cost of greater risk or more thorough work. Overall, however, they still outperform bonds. So for investors who want a higher return on their money than they can achieve in the bond market, they can still be an attractive alternative.
This stage is still in the growth phase, so it gives you a good opportunity to choose one or more index-tracking funds for yourself. Especially if that fund tracks an equity index.
Although if you want to focus on safety, not just profit, then a bond could still be a suitable investment for you.
The fourth stage of the market cycle
The beginning of the culmination, here the growth has already stopped.
What happens at this stage of the cycle?
In the next section you can observe the state of culmination.
Sales are no longer growing and profits are falling as costs rise.
In the economy, you can see this in this market cycle
You can still see an increase in the price of raw materials due to the previous demand for them, even tied up in contracts.
This rising commodity price further reduces the profit potential of public companies, which is why capital starts to look for other, more profitable or simply safety-focused ways to invest. As demand for equities falls, this will be reflected in their prices.
And there was already less demand for bonds in the previous phase. Don’t be fooled if someone offers you a bond at a high interest rate. This is not necessarily a sign that the company has huge growth potential. You may be dealing with a junk bond for a company that is no longer financed anywhere else.
Choosing investment instruments
At this point, you should add assets to your investment basket that will protect you in the event of a downturn. It is necessary to pay attention to the investment risk at all stages, but it is important to focus on it here.
This can be done in a way that is inherently lower risk, but you also have the option of choosing an asset that is priced to move in the opposite direction to these economic events. If you understand investing or have someone to help you, these are the assets that have a negative beta.
The fifth stage of the market cycle
Stage 5 is already a stage of recession.
What happens at this stage of the cycle?
Then GDP falls, creditworthiness deteriorates and credit availability becomes tighter. Sales also fall, productivity and profits also fall.
What you generally see in the economy at this time is that the price of everything falls. The falling demand for equities has already begun in the previous section, and this is more strongly reflected in prices here. There was no longer any demand for bonds either, due to harder borrowing and rising base rates.
As companies are not producing as much, they do not need as much raw materials, which is why we are also seeing a fall in prices.
In the economy, you can see this in this market cycle
The defensive sector can then perform well at this stage, although there is demand for this sector at any stage anyway.
Examples include healthcare, utilities and consumer staples. Just because it is a crisis, people still need to eat and go to the toilet.
In other respects, during a recession, stocks and commodity stocks fall in performance.
Choosing investment instruments
If you do not want to invest in shares, a well-chosen bond can be considered safe at this stage. By properly selected, I mean primarily the credit rating of the issuer and the terms on which the bond was issued. A bond is a debt instrument, the interest on which must be paid in any case. At this point in time, you are better off with fixed-rate bonds than, say, those with an inflation-linked interest rate.
What can still do well in a recession is any investment that typically moves in the opposite direction to equities. That is, one with a negative beta. It will move in the opposite direction to the market. Gold is a typical example. Its price has either fallen or at least not risen relative to equities as long as demand for equities has been strong. At this stage, and if you have acted in time, the previous one may be an escape route for you. It serves as a store of value, so while the dark clouds are clearing, you can direct some of your money from equities here.
The sixth stage of the market cycle
The sixth stage is also part of the recession, when, depending on the form the crisis takes, problems deepen or more and more people feel or think that spring is coming.
What happens at this stage of the cycle?
The hardest thing about this period is that no one knows how long it will last, whether there will be another downturn, the only thing you can know is that it won’t last forever.
In terms of economic trends, you can see that low demand for commodities and equities is pushing prices down, or in a lucky scenario, the market is just sideways. For you, both of these mean that it’s a buy rate for your long-term decisions, and if you’re looking for short-term results from them, well, it’s not the time yet.
Central banks and governments, on the other hand, are introducing stimulus packages to maintain balance, making it easier to borrow.
From the above, you can guess that this is the time for bonds to be in their revival phase. The other options are either still or no longer in play, but borrowing is easier.
Choice of investment instruments
What you can invest in depends on your own time horizon and the amount of capital you have.
Thinking long term at the end of this phase, you can even think in terms of equities as you approach the next phase, taking advantage of the crisis and the cost average effect.
Otherwise, you can mostly move in the bond market. Gold may not be a good option at this point, as it has already seen a significant increase.
Market cycle for real estate
You may rightly wonder that there was a lot of things mentioned, but not real estate.
Real estate works in a similar way to equities, only it usually has a far greater capital requirement. Another difference is that the sale and purchase of property, and indeed the whole property market, is much slower.
That is why it will track equities with a time lag. When people have money, they will channel it not only into equities but also into other forms of investment.
If they need to borrow to do so, they will do so at a time when borrowing is relatively easy and cheap compared to other stages. But it takes time to go through the process of finding or even building the right property. The same is true before or during a recession.
The peak phase will not happen all at once everywhere.
Note that while price rises may have slowed in a big city, property in the suburbs is still selling for higher and higher prices, even if it is already priced in gold.
But even in a recession, buildings that have already been started must be completed, even if at a low price, but either they must be sold or rent, otherwise they are guaranteed to fail.
How can you use market cycles to your advantage?
At different times, you can achieve higher returns on different investment vehicles.
Two things follow from this:
One is that there is no perfect investment.
There is no such thing as having just one type of asset and it will serve you whatever the market situation. At one stage of the market cycle, one asset will be of greater use to you, at another stage something else will be good, while your investment that performed well in the first stage will either stagnate or fall straight down.
Your own investment basket (i.e. portfolio) is an appropriate construction of your own goals and the market cycle.
At this point, pay attention to at least two things:
- Diversification: while it sounds good to have chosen a particular sector, diversify your money in several directions.
- Correlation: This shows the price movement of two or more investments together. If you’ve chosen assets that move in the same direction in response to the same market action, say going up in the same way, don’t be surprised if they move down together.
You can mitigate your own risk by either choosing neutral assets or by also buying assets that move in the opposite direction.
Why is it important for you to know these?
To achieve higher profit / lower loss.
While no one can ever tell you exactly when a particular market cycle starts or ends, if you know which asset will give you a higher return in a given market, you will be able to move in that direction.
Many small investors have suffered losses because they panicked after the crash. Although I drew a nice regular arc, it was just for clarity.
In real life, a setback can be a long downhill slope, or it can be a sudden fall.
Note that I did not say it would be easy, because that is not necessarily true. Even in the middle of a long tunnel, it is hard to imagine that there will soon be light, and on a roller coaster there are many people screaming down.
If you know it’s just the start of another round, you can take things more calmly. And you can save yourself a considerable amount of loss.
If you want to build capital, patience is important to give money time, but so is foresight. Because remember.
Rome was not built in a day, but it took only a few hours to destroy Nagasaki.
If you would like to make an appropriate decision, please contact us to arrange an appointment.