4. Understanding Business and Market Cycles

Curated By
Vivek Gadodia
System trader and algo specialist

Skill Takeaways

  • Meaning of business and market cycles
  • Phases in business and market cycles
  • Their relevance and criticality for prospective traders

We’ve already seen how economic activities have long-lasting impact on markets. 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 difference between business and market cycles. 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 cycles.


Why learn about market and business cycles

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 helps in making appropriate policy decisions.

 

Phases of business or economic cycles

Gross Domestic Product (GDP) is a key barometer of any economy. Any fluctuation in GDP results in business or economic cycles. While the duration of any business cycle is unpredictable, it has been widely observed that there are four phases to a business cycle. They are:

Expansion: This phase 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, capital employed and profitability increases, leading to healthy GDP growth. This is the best phase in the economic cycle.

Peak: In this stage, 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.

Contraction: 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.

Recession: This is defined as a phase when GDP declines for two consecutive quarters. 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.

Trough: A trough is the lowest swing or the lowest point of the contraction. 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 market cycle include:

Accumulation: This phase 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 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.

Distribution: This is the peak of the bull market run. 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 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 cycle. Prices are a reflection of human behaviour and actions expressed in markets.

Points to remember

  • Identifying business or market cycles is quite challenging
  • It is also difficult to map market cycles to business cycles as the market usually moves in anticipation of the future
  • Markets move much ahead of actual economic recovery or downturn
  • Buying the bottom and selling the top can be tricky under these circumstances
  • Market cycles can be quite lengthy and test investor patience
  • This results in investors either selling too early or buying too late
  • It is always wise to plan for long-term investment by buying at dips, sitting through the bear phases and waiting for the recovery to happen
  • Patience is a virtue in this game
  • Risk management is primary and a supreme skill one has to build to survive, since cycle lengths and correlations across markets may change
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