Find out what is the difference between a market and an economic cycle.
From the depths of recession to the peak of recovery, from overconfidence to despair, there probably isn't a trader on earth who hasn't experienced the highs and lows that come with riding the financial markets rollercoaster.
It is impossible to make money all the time but, by understanding market cycles and the behavioural tics from which investor suffer, you can go a long way to smoothing out what can be a rough ride.
This article explains economic and market cycles, helps you recognise the emotions that can consume investors and lead to poor decision-making, the tell-tale signs conditions are about to turn, and how you may adjust your portfolio accordingly.
Market cycles explained
A market cycle is generally accepted to be a long-term pattern of alternating periods of growth and decline, although there is no standard industry definition.
What is the difference between a market and an economic cycle?
Market cycles tend to be leading indicators for economic cycles, usually by around six months.
How do I identify the stages of the market and economic cycle?
There are four broad terms used to describe each stage of market and economic cycles:
Prices bottom out||
Early bull market||
Prices begin to rise||
Prices have recovered||
Overconfidence, stimulus withdrawn|
Early bear market||
Volatile prices fall||
Why is it important to identify each stage of the cycle?
- It impacts the assets an investor may be buying, selling, and avoiding.
- It helps investors identify risk and hedge their exposure.
Market phases vary between different asset classes such as large-cap stocks, small-cap stocks, cash, gold, and bonds, and can also vary within asset classes - for example, within equities, the industrial sector might outperform healthcare.
- An investor may increase risk and asset allocation to stocks during bear markets - valuations are moving lower
- An investor may decrease risk and asset allocation during the speculative bullish stage – between bull and early bear market phases when valuations are moving higher.
How can investors recognise a cycle?
Industries and sectors tend to perform in a certain way during each stage of the cycle:
But beware the Black Swan
A 'Black Swan', a phrase coined by Nassim Taleb in his 2001 book
Fooled By Randomness, is an unprecedented event which causes shockwaves in financial markets. They can be negative, such as the 9/11 terrorist attacks, or positive, such as the fall of an oppressive political regime. Although the market cycle model can help traders to forecast asset price movements and control their exposure to risk, there is always the possibility an unpredictable event such as this could derail their investment strategy.
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