Market cycles are a fundamental concept in financial markets, characterized by recurring phases of economic expansion and contraction. These cycles influence the behavior of investors and the overall performance of the stock market, making it essential for investors to understand and navigate them effectively.
The Continuous Nature of Market Cycles
Market cycles are perpetual, rarely transitioning from "overpriced" to "fairly priced" and stopping there. Usually the growing pessimism will cause the markets to continue right through from “fairly priced” and on to “underpriced” before going back up to “fairly priced” and then “overpriced” again and this cycle continues on and on.
You can imagine it to be something like a pendulum. When you pull a pendulum to the extreme left and release it, it causes the pendulum to swing back to the mid point before swinging all the way to the extreme right. As long as there is someone who continues to exert a force on the pendulum, it will continue to oscillate about the midpoint.
Forces Driving Market Cycles
What is this “force” that causes the market cycle to continue? Several factors drive market cycles, including changes in the economy, corporate profits, investor attitudes towards risk, investor psychology, and credit market conditions. These elements are interrelated, with each influencing the others in a complex web of cause and effect.
For instance, the 2020 market crash was triggered by the exogenous shock of the COVID-19 pandemic, leading to economic shutdowns and business struggles. In contrast, the 2022 market downturn resulted from central bank interventions to combat inflation, including steep interest rate hikes, compounded by geopolitical events that spiked oil prices.
How the Market Cycle Works
(Do take note that this is just a general example of how a market cycle may look like and the exact triggers for each new bull and bear market would differ.)
Perhaps let’s take a look at how a complete market cycle looks like to have a clearer idea.
During periods when the economy is growing strongly and corporate profits are rising and beating expectations, the news media tends to cover more on the positive economic outlook and earnings.
This boosts the confidence and optimism of investors and they gradually increase their risk tolerance to buy more stocks. Over time, this turns into greed as some investors chase after the stock prices, thereby driving up the stock market.
At the same time, capital markets are open and it is easy to make borrowings. Default level is low.
As the stock market continues to rally, investors’ greed and confidence build up. Some would even boast about their intelligence for the investment profits made. At this point, the majority of the market participants think that it is impossible for the stock market to decline!
It follows that the risk is at the highest level now due to extreme greed and optimism. However, the majority of the investors think otherwise. Many of them adopt the “it’s different this time” “the market rally will never stop” mentality so instead, they perceive the risk to be low. That’s why they continue to buy by chasing after the prices even though rationally, it is a more appropriate time to call for defensiveness.
Based on what we witnessed in the stock market over the last couple of years, do you think the stock market will just continue to always only rally up? At this juncture, what we need is just either a deterioration of the economic condition or disappointing corporate profits or increasing default in borrowings to trigger a decline in the stock market.
As the economy eventually slows, corporate profits decline and the level of defaults increases, investors begin to worry about the outlook and shift towards being more risk averse now. The defaults cause capital markets to close which in turn results in more defaults.
Fewer investors are now willing to invest in the stock market and some of them are selling away their existing positions to keep out of the markets. Hence, stock market prices cascade downwards. As stock prices fall, investors’ pessimism and fear of losing more money grow stronger and more investors are rushing to sell.
News media would also now be reporting mostly on the negative outlook which induces more fear among market participants. Eventually, even investors who have been holding on to their positions capitulate and sell. The stock market cycle is now at its bottom.
It may seem too pessimistic for any one to stay in the market but in fact, this is the time when we should turn more aggressive by buying stocks of quality businesses at depressed prices. However, due to the psychology and emotions of investors, most of them would do the exact opposite and stay away from the markets.
But remember the market cycle doesn’t just stop here! Eventually as the economy recovers and the credit market reopens, defaults will reduce and investors begin to shift towards risk tolerance and participate in the stock market again and the stock market will rally up. Those who took advantage of the market crash to accumulate stocks would then be able to profit from the rally.
How to Cope with Market Cycles
Therefore, navigating market cycles effectively requires adjusting the risk posture of your investment portfolio in response to prevailing conditions. There are 2 types of risks that investors face in the stock market: risk of losing money and risk of missing out on the opportunity.
When the majority are overly greedy and risk-tolerant, it's prudent to adopt a defensive stance. Conversely, when fear dominates, it's time to be aggressive and focus on accumulating assets.
Using Technical Analysis to Position the Risk Posture of our Portfolio
Technical analysis is a valuable tool in this regard. While it's impossible to predict market movements with complete accuracy, technical analysis helps identify the likelihood of market declines or rebounds by studying price trends and technical indicators.
For example, instead of chasing prices, it's more favorable in terms of risk-to-reward to buy when stock prices retrace to support levels, where the probability of a rebound is higher. During market crashes, accumulating positions in fundamentally sound businesses can be a wise strategy.
Conversely, when stock prices hit strong resistance or are overextended, it may be prudent to offload some positions and reallocate capital to stocks with better risk-to-reward setups.
While we can’t pinpoint the exact timing of market tops or bottoms, we can identify the tendencies or likelihood of market declines or rebounds at specific price levels. This is achieved through Technical Analysis, which allows us to study overall market sentiment by analyzing price trends and using technical indicators.
Market cycles are an intrinsic part of the stock market, driven by various factors and forces. Understanding these cycles and adjusting your investment strategy accordingly is crucial for long-term success. By using technical analysis to gauge market sentiment and identify favorable entry and exit points, investors can navigate market cycles more effectively. Remember, when others are greedy, be defensive, and when others are fearful, seize the opportunity to be aggressive.
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In this workshop, we will guide you on how you can read the stock charts to understand the market sentiments and to identify buying and selling opportunities to maximise profits.
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