Skill Sheet: What You Will Learn Here
- Meaning of business cycle
- Meaning of market cycle
- Phases in business cycle and market cycle
- Relevance of business cycle and market cycle for investors
We have already seen how economic activities have a long-lasting impact on markets. The economy and markets are subject to cyclicality, which means they experience periodic fluctuations or wild swings. Cycles have distinct patterns that mirror the past and can be studied to make informed decisions.
Let’s understand the business cycle meaning and understand the difference between a business cycle and a market cycle with examples. While economic fluctuations are known as business cycles, stock market fluctuations are known as market cycles. As economic activities affect the markets directly, business cycles influence market or trading cycles.
Why learn about the market cycle and business cycle
In his book Mastering the Market Cycle: Getting The Odds On Your Side, renowned economist Howard Marks says, “most upside excesses and downside overreactions in business and market cycles are overreactions in the investor psychology”. Understanding these extreme fluctuations is paramount for avoiding damage from these wild swings.
For entrepreneurs, it is important to identify the current phase of the business cycle and accordingly plan their resources to avoid any sudden change in the business cycle.
For investors, understanding the market cycles helps in evaluating how various asset classes, such as stocks, bonds, real estate, commodities, etc., have performed during the various phases of a business cycle.
For governments and regulatory authorities, understanding business cycles in economics helps in making appropriate policy decisions.
Phases of a business cycle in economics with examples
Gross Domestic Product (GDP) is a crucial barometer of any economy. Any fluctuation in GDP can result in a change in the business cycle in economics. While the duration of any business cycle is unpredictable, it has been widely observed that there are four phases or types of business cycle. They are:
The expansion phase in a business cycle begins with a sharp recovery from a recession. An economy is said to be expanding when business activities pick up, demand beats supply, production and prices see an upturn, unemployment falls, and capital employed as well as profitability rises, leading to healthy GDP growth. This is the most euphoric phase in a business cycle in economics.
In this stage of a business cycle, production and prices reach the maximum level, demand is seen to fall and wages and employment rates also hit the ceiling. The demand and supply are at equilibrium.
After the economic growth has hit its peak, it slowly begins to recede. Contraction is marked by higher interest rates, inflation, falling demand and excess supply. Contraction can be of two types - recession and depression.
This is defined as a phase when GDP declines for two consecutive quarters in a business cycle. If a recession continues for several years, it is termed depression. The Great Depression that began in the United States lasted for a decade, starting in 1929 and only ending during World War II in 1941.
A trough is the lowest swing or the lowest point of the contraction in a business cycle. In this phase, the economy hits rock bottom from where it cannot go down further. From this point onwards, the economy starts to rebound and recover. The recovery lasts till the GDP returns to a stable and steady growth rate. This marks the beginning of the new business cycle.
Phases of market cycles
Market cycles represent fluctuations or swings in stock prices over time. They have a close association with business cycles and impact investment decisions. While GDP is considered an economic barometer, stock markets are considered a measure of investor confidence in the economy. Market cycles tend to be more critical than business cycles as investor sentiments hinge on them.
Market cycles also have distinct phases that begin with increasing optimism leading to a bullish peak and then gradual pessimism resulting in a bear market trough. Also impacted by political and geopolitical variables, they are inevitable as well as unpredictable. Understanding market cycles can help in making decisions based on the phases. While it is impossible to pinpoint the top or bottom of a market cycle, investors can anticipate the beginning or end of the phase and make their decisions accordingly.
This is because, sometimes, the market cycles can remain detached from business cycles for few months, and the stretches can be far in excess on either side, i.e., both in rising as well as in falling markets. Finally, traders and investors must exercise risk management to survive in the markets. For example, in 2007, when the Housing Bubble burst in the US, it was widely expected to spread across the world. Indian markets witnessed a massive rally in stocks from July to December 2007 before eventually crashing in January 2008.
The four phases of the market cycle include:
This phase in a market cycle is marked by investor optimism after a prolonged bear market. In this phase, stock prices are low and value is perceived to be high. This phase corresponds to the expansion phase of the business cycle.
Mark-up or uptrend:
The mark-up phase in a market cycle is that of exuberance, where investors keep investing as the market continues its upward trend with increasing volumes. The valuations in this stage start to increase to historical levels. This phase is known as the bull run, which eventually leads to the peak of the market cycle, known as the bull market peak.
This is the peak of the bull market run in a market cycle. As the excitement of the bull run begins to ebb, many investors get trapped in this last phase, with prices struggling to move up and volumes beginning to dry. This phase can be quite prolonged and the slightest of negative news can trigger a sell-off.
Mark-down or downtrend:
This phase in a market cycle is the exact opposite of the mark-up or uptrend, where exuberance turns into disappointment resulting in extreme pessimism. A sell-off is triggered and prices fall rapidly as investors lose confidence and sentiment turns negative. The markets come in the grip of the bear phase, eventually forming a bear market trough. Hereon, markets cannot go down any further and it is before long when they start to recover and begin a new market cycle. Prices are a reflection of human behaviour and actions expressed in markets.
Points to remember
- It's difficult to map market cycles to business cycles as the market usually moves in anticipation of the future
- Patience is a virtue in this game
- Risk management is a primary skill needed to survive, since cycle lengths and correlations across markets may change