Can market cycles be mastered or are we gambling? Investing well means buying cheaply and selling dearly. But how do you know what the best timing is? What about all the high flights, speculative bubbles and crises? This article tries to explain how and why the markets are so fierce. They show you how to keep a cool head in the exuberance of a boom as well as during the general depression of a crisis and make the right investment decisions at the right moment.
This post is for,
– beginners in the investment business who want to invest their money profitably
– Investors who have already invested in assets
– Experienced investors who want to take a step ahead of their competitors
Gain a sensitive and lucrative understanding of short-term market cycles
There are some investor legends with their own asset management firm and over 40 years of business experience. What do you think is the most frequently asked question by clients? Quite simply, how do I know when to buy and when to sell in order to best benefit from market developments?
This article gives you an answer to these and many other questions about investment: When is it worthwhile to get into the upswing and when do I start investing again after a crisis? And how do I deal with the short-term capers of prices?
You’ll find out why economies and markets around the globe are growing in the long term, but in the short term they’re always going crazy. You will also learn which signals serve as valuable mood barometers and how to invest successfully with a cool head and counter-cyclically.
We’ll also show you
– why, as a successful investor, you always swim against the current,
– why every bubble must burst at some point, and
– why supposedly risk-free transactions actually involve the greatest risks.
Investors try to buy the highest possible assets at the lowest possible prices
How do you master market cycles? Star investor Howard Marks hardly ever gets a question asked more often – both by experienced investors and by bloody beginners. So let’s start all over again.
Investors invest money in stocks and bonds. The selection of their investments is called a portfolio, from which they hope to achieve the highest possible increase in value over the years. But how do they know which investments will increase in value? That’s where it starts: they don’t know. They can only speculate, assume and estimate. Some of their estimates are more accurate than others, but in the end they can’t predict anything. They can only try to practice the art of well-founded conjecture.
That’s easier said than done. Suppose you are an investor: Why should you in particular be more correct with your assumptions than others? Other investors are very likely to know as much as you do about the economic and geopolitical events affecting the market: Wars, price slumps or imminent technological innovations. You are likely to draw your knowledge from the same news, technical articles and statistics. Your estimates are almost certainly as good as yours.
So forget the long-term predictions. You’d better concentrate on what investors call “what you know”. Use this concrete and available knowledge for well-founded assessments of the near future.
What one can know includes all available information about the true value of an asset. Imagine you want to invest in a company. Look at the price at which its shares are traded on the stock market. You then compare this real market value with the purchase price of the shares. If the purchase price is below the market value, you are on the trail of a lucrative transaction.
Actually, your goal is simple: you want to buy your assets cheaply and then wait for the market to appreciate.
Let’s assume, for example, that the real estate market is sliding into crisis. Property developers cannot service their loans and have to abandon ongoing projects. In such phases, with a bit of luck, you can secure a stake in properties whose material value alone is already above the price at which you buy.
Such favorable opportunities increase the likelihood that your portfolio will increase in value. Some investors would say that the only thing is to buy cheap and sell expensive. But some believe that the superior investor has a third component in mind: the financial cycles.
Financial cycles are like natural cycles, but less predictable
Let’s start over here, too: What is a market cycle? Investors define the market cycle as a repetitive pattern in the market – a repetitive process. There are countless such cycles in nature: the change of day and night, the chronology of the seasons, the moon’s orbit around the earth. It is not for nothing that we speak of a woman’s menstrual cycle.
These natural cycles run with such regularity and reliability that we can be one step ahead of them in many ways: You can get warm clothes early enough for the winter and set an alarm when you need to get up early. The cycles of markets in economics and finance are not nearly as easy to predict. But that doesn’t mean they don’t exist.
Imagine, for comparison, that the earth would not rotate around its axis at constant speed, but sometimes faster or slower. No one could say for sure when it will be day or night.
The situation is similar with the market cycles. Nobody can say with certainty when the brilliant light of an economic peak will darken into the threatening darkness of a price collapse. In the long run, prices may be in similar curves, but in the short term it is impossible to predict the deviations.
We can therefore never speak of certainties in relation to economic cycles and financial cycles, but only of tendencies. One tendency is ultimately what will happen according to the well-founded assumptions and careful calculations of an informed investor.
If, for example, a long boom has raised market prices and investor sentiment to a record high that can no longer be increased, a crash will inevitably occur sooner or later. Prices fall and investors become anxious and pessimistic. When this collapse will happen and how devastating it will be is unpredictable. But that doesn’t mean that you as an investor can’t protect your portfolio while the bubble in the market is growing.
The cycles of the financial markets are completely different in the short term than in the long term
Mark Twain is said to have said history doesn’t repeat itself, it rhymes. The same can be said about the cycles of the financial world. They are never identical, but in the long run they all follow the same repetitive pattern.
Let’s illustrate this with a concrete case. The so-called dotcom bubble, which burst in 2000, is an impressive example of a boom-bust-cycle, i.e. the swelling and bursting of a speculative bubble.
Here’s what happened: In the mid-1990s, the Internet hit like a bomb. The world of finance expected gigantic profits around the globe.
Venture capitalists pumped vast amounts of capital into new online companies that sprang up like mushrooms everywhere. The only problem was that most of them had little chance of success.
In the initial euphoria, stocks shot to unprecedented highs and venture capitalists recorded triple-digit gains. This attracted even more capital, with which further Internet agencies were founded. A huge bubble formed.
In the end, only a small number of these companies were able to establish themselves on the market. The rest went broke. Many venture capitalists lost all their investments and share prices plummeted. The bubble burst.
If one wanted to depict this development of the markets in a graph, one would get the shape of a church spire. Risk capital investments shot up abruptly in 1999, reached an absolute high in 2000 and fell abruptly at the end of the same year. That is what happens when you look at the short-term development between 1999 and 2001.
Since then, however, the risk capital market has recovered to a large extent. If you expand the same chart until 2018, you will see that prices are now more than half as high as at their absolute peak in 2000. In the long run, the risk capital market has grown over the last 20 years, even though there have been wild ups and downs in between.
Most markets, industries and companies follow exactly this pattern, even if the swings may be less extreme. On average, they are all gradually gaining in value. This trend towards positive long-term growth is known as the Secular Growth Rate. But what exactly is the reason why this long term climbing rate is so strong in between?
The most important factor for short-term market fluctuations is the psychology of investors
Most of us seldom tilt abruptly from one emotional extreme to the other in everyday life. Sure, we have good and bad days, but we don’t or seldom roll between frenetic flights of fancy and abysmal despair. At first glance, it may sound surprising that it is precisely such bipolar mood swings that are the main reason for the short-term swings in the markets.
Let’s take a good look. In phases of great and rapid growth, such as the Internet boom between 1995 and 2000, investors become mad. They surrender to the galloping belief that growth is eternal.
Whether they are too young to remember the inevitable price slumps of past cycles, or too confident in the potential of new markets, in the end they ignore the knowledge of the top and descent pattern in the euphoric belief that this time everything will be different.
The euphoria spreads like wildfire. Other investors are caught in a pull and buy shares until the prices are far above the value of the long-term growth curve. Nevertheless, more and more investors are jumping up because they are afraid to miss the big profits of the boom or because they really don’t see the bubble bursting.
Then, at some point, fear spreads. The first investors become aware that prices have risen far too high and that the mood curve is approaching its peak. They begin to sell their shares and push prices down, which in turn unsettles other investors. Soon everyone sells and prices fall well below the value of the long-term growth trend.
That reads so simply and conclusively, but in the moment itself it is hard to resist the ecstasy of the herd. Even Isaac Newton, one of the brightest and most prudent minds of all time, could not resist her maelstrom.
In January 1720 Newton was mint master of the English crown, thus as a kind of finance minister. At that time the stock of the English South Sea Company was 128 pounds. The euphoric speculation on gigantic profits in the South Sea trade caused prices to rise. Newton realised that prices were artificially inflated and sold his shares worth a total of 7000 pounds.
He correctly predicted the beginning of the boom bust-cycle: prices shot up to 1050 pounds per share by June 1720 and fell below 200 pounds again by September. But here it comes: Newton let himself be lured out of the reserve after all. When he saw all the people around him making juicy profits, he bought back his shares at the peak of the price trend and finally lost everything – more than 20,000 pounds in total – when prices collapsed shortly afterwards.
It is best to invest when the risk is high and sell when the risk seems low
So it’s important to resist the pull of manic profit mania. However, it is equally important not to fall into depression in times of crisis.
Investors around the globe follow the slightest fluctuations of the markets closely on a daily basis. Very few of them keep an eye on the signals that tell them anything about their own position in the investment environment. Experienced and sovereign investors, on the other hand, pay attention to such details.
Many investors forget everything they know about risk in the madness and greed of the upswing. They continue to buy frenetically even when prices have long been too high and the probability of a price collapse is highest. Can market cycles be mastered that way? No.
The higher the upswing, the lower the return on risky investments. In the collective exuberance of buyers, sellers can demand high prices at lousy risk premiums, which further increases the risk of loss for investors. At the latest with sentences such as “The market cannot collapse at all” or “This time it is different” the alarm bells should ring with you.
In other words, don’t let me drive you crazy. This also applies to the reverse scenario after a price collapse or crash. Investors are suddenly hopeless and scared. All those who have lost something hold back and assume that the market will now freeze forever in shock.
These are the best conditions for lucrative investments! The default risks are low and the risk premiums are as high as the probability of an imminent upswing.
In summary, this means that you have to invest anticyclically. If everyone thinks that the risk for investments is the lowest, it is in reality the highest. You take the least risk if everyone thinks the risk is high.
After the financial crisis of 2007 and 2008, the construction sector virtually came to a standstill. In 2010, the number of newly started construction projects was even at its lowest level since 1945, when the effects of the Second World War weighed on the real estate market.
In 2010, many people were also interested in building their own homes. The most important parameter was therefore the ratio of new construction projects to population, and this figure was only half as high in 2010 as in 1945. The market situation was poor, but the statistics suggested that demand for construction projects would increase.
Contrary to the prevailing opinion that the construction sector would not recover for a long time, investors bought one of North America’s largest private construction companies. It was an investment that more than paid off.
In the long run, the economy will grow through the total number of working hours and the productivity per working hour
All this could now lead to a question: If the Secular Growth Rate is always positive, couldn’t you just let your money work for you while the short-term capers of the courses balance out in your favour?
Unfortunately, it’s not that simple. Long-term economic growth is also subject to certain cycles. They are only much longer and therefore difficult to keep track of. But there are also a few key figures that offer orientation.
One example is the long-term development of the gross domestic product (GDP) of the USA. GDP can be calculated as follows: The total number of hours worked in the economy as a whole is multiplied by the result of hours worked per hour. This means that a country can increase its GDP in exactly two ways. It either increases the number of all hours worked or it increases productivity per hour.
The easiest way is to increase the number of hours worked in the country by increasing the number of workers. In fact, GDP growth almost always correlates with population growth.
After the Second World War, for example, the US population grew rapidly. Even in this country, the phase is known as the baby boom. When the children born between the 1940s and 1960s became fit for work, the US economy recorded tremendous growth rates. There were simply more employable workers on the market. The increase in hours worked, in turn, increased economic growth.
GDP growth through labour productivity growth, in turn, depends on technological progress. From 1800 onwards, steam and water-powered machines replaced human labour in various areas and increased labour productivity many times over. Work processes that had previously been done by hand in small shops were now being moved through the machines of large factory buildings in no time at all. The result was gigantic economic growth.
The GDP of the USA has been growing for decades on average between two and three percent per year. But this is the average long-term growth rate. In between, however, there may still be crises from which the economy sometimes fails to recover for years.
The birth rate variable may also vary due to various influences, such as wars, unfavourable economic conditions or social developments such as the recent tendency of young people to postpone family planning. In the long run, such a decline in the operational labour force may well lead to an economic downturn.
So don’t rely on the short-term promise of a rosy future that may never come true. That’s why superior investors pay close attention to how they behave most cleverly in the short-term cycles of the market.
Can market cycles be mastered – summary
The cycles of the economic and financial markets follow very specific patterns: in the long term they grow steadily, but in the short term they repeatedly hit up and down sharply. The majority of investors react frenetically or panic-stricken to these high flights and crises, but experienced, successful investors remain cool. They watch the changes closely and benefit by making prudent and anti-cyclical decisions.
Never stop reading! Never.
Many investors reinforce the bubble effect themselves by only consuming news and specialist literature on finance. In history books, for example, you can learn a lot about short and long-term cycles. The Roman Empire, for example, went through an impressive large cycle with many violent swings. The watchful investor will find important lessons even in fiction about how human emotions influence the mood of the markets. So never stop broadening your horizons!
If you are new to investing, read our article How to get out of the trap of the 9 to 5 scam
If you want to learn more about market cycles, have a look at Investopedia – Market Cycles