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Market Cycles Turn, Turn, Turn
To Every Asset Class There Is a Season
Comparing investment markets to the seasons may seem a bit farfetched. But it can actually be an instructive way to introduce the concept of market cycles — the recurring expansions that push prices up followed by the inevitable contractions that drive prices down, only to be followed by yet another expansion and another contraction.
Of course, a major difference is that unlike a season, a market cycle doesn’t fit neatly into an annual calendar. Then again, there’s no guarantee snow will fall in December or flowers will bloom in March (pace, readers in the Southern Hemis-phere). So it’s worth reminding yourself that whenever the stock market enjoys weeks of steady gains or suffers months of flat or falling prices, it’s just a small segment of a much longer loop.
The Temperature of Investors
What makes a market cycle truly different from the seasons, however, is that investors have a major impact on the former and absolutely no effect on the latter.
That’s largely because a stock market surges when investors generally are buying and falls when investors are selling. A number of factors, primarily economic and political, influence these decisions.
For example, when corporate earnings are strong and employment is robust, investors want to profit from this prosperity by owning stocks. But if earnings fail to meet expectations or investor confidence is shaken, investors desert stocks for safer alternatives, causing the stock market to slump. Then, as the economy is re-energized — perhaps encouraged by a Federal Reserve Board cut in interest rates — the pace of stock investing picks up again.
This movement from high point to low point and back to high is known as a full market cycle.
Different Markets, Different Cycles
Other investment markets, such as those for bonds, commodities and real estate, have similar cycles. Although the up-and-down patterns of these cycles are the same, their timing and duration aren’t. A full stock market cycle, for example, may take less than a year, but in the case of real estate, it can stretch for a decade or more.
In some cases, the markets in different asset classes are correlated, which means they’re influenced by the same factors. For example, stock and bond prices are both affected by interest rate changes. In contrast, interest rates have little or no effect on the price of corn and wheat, while weather and market demand have a major impact on their prices. For this reason, agricultural commodities and bonds are described as noncorrelated.
Riding a Market Cycle
You can deal with market cycles defensively by resisting the impulse to sell off your holdings when your portfolio is losing value. Although it’s a good idea to shed individual investments over the long term that aren’t meeting your expectations, it’s almost never smart to sell extensively when an entire asset class is slumping. You might be selling an investment for the wrong reasons and taking a loss in the process. And you won’t be in a position to benefit when the market bounces back, since you’ll no longer own the investments that may increase in value.
Another, and perhaps more effective, way to deal with market cycles is to be proactive. This means when investment prices are falling across the board, it’s often time to buy. You’ll not only pay less for stocks, but when the market rebounds — as it invariably has — you’re positioned to share in the gains.
You can also adopt an asset allocation strategy to ensure your portfolio always contains a variety of asset classes, including some that correlate and others that don’t. For example, if you always own stocks and bonds in the proportion you’ve determined suits your goals, time frame and risk tolerance, you’re positioned to benefit from whichever of the two asset classes is providing the better return at a given time. (Editor’s note: Some people don’t see any reason to own anything other than stocks. They view asset allocation as an attempt at market timing and a way for some brokers to generate commissions by increasing transactions.)
Market cycles are a fact of investing. Over time adopting a strategy to capitalize on them, rather than buying and selling impulsively in response to immediate market fluctuations, can potentially yield far better results.
Virginia B. Morris is the Editorial Director for Lightbulb Press.