Economic and market cycles (boom and bust cycles) are two interconnected economic concepts. Economic cycles relate to the fluctuations between periods of expansion and contraction within the economy, whereas market cycles refer to the fluctuations in financial markets. Although they are often intertwined and market cycles can be influenced by economic cycles, they can also run independently of one another based on entirely different contributing factors.

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What are Economic and Market Cycles?

Understanding economic and market cycles is essential for investors. Knowledge of how these cycles work can help guide investment decisions and navigate changing economic and market conditions.

Economic cycles measure the overall activity within the economy, while market cycles indicate the health of public markets. Although they are closely interconnected, they have different fluctuations, expansions and contractions (growth and declines). The broader economic conditions impact the financial health of companies, which in turn influences the public markets.

During an economic expansion or “boom,” the positive effects flow into the stock market, as what’s good for the economy is often beneficial for public companies. Conversely, an economic downturn affects the profitability and operations of companies, potentially leading to a “bust.” Both economic and market cycles constantly fluctuate between “boom and bust” cycles.

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Nothing goes in one direction forever… Cycles always prevail eventually… Just about everything is cyclical.

Howard Marks

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It’s extremely challenging, if not impossible, to time these cycles and make investment decisions based on their interpretation. Therefore, having a strategy that adapts to changing conditions to minimise risk during downturns and maximise opportunities during expansion can lead to better returns, both financially and emotionally.

The market’s “boom and bust” cycles are heavily influenced by emotions and the psychology that impacts investors during bear and bull markets. Studying and understanding these cycles and the broader impact of the economy allows investors to plan for the long term and navigate the “roller coaster” of public markets.

Being aware of these cycles is crucial for long-term investors to remain committed across a range of market conditions. It’s not about trying to predict with a crystal ball the future. It’s about understanding patterns, past trends, and the cyclicality of all the contributing factors to help plan for the best and prepare for the worst.

Differences between Economic and Market Cycles.

Market cycles are not identical to economic cycles, although they are influenced by them. The economic cycle can be impacted by a broad range of areas. All countries will go through this constant change in economic activity. Changes in demand and supply, government policies, and growth of outputs such as jobs, income, and spending all impact the economic condition.

Market cycles are impacted by many of these factors; however, they can also be largely driven by investor sentiment and monetary policy, in addition to economic activity. The market cycle refers to the fluctuation of stock prices, bond yields, and commodity prices.

So, the major difference is Economic cycles reflect the rise and fall in economic activity, while market cycles represent the growth and decline in businesses.

Market cycles are referred to as bull and bear markets or sell-offs and rallies. During economic expansion, the stock market will go through a boom and rise in tandem with it. The markets will usually fall when economic activity contracts.

A boom-and-bust cycle is simply the flow between stages of the economy or market from growth to a decline in activity and then eventually a recovery.

Key Differences:

Scope: Economic cycles refer to the overall economy, while market cycles focus specifically on financial markets.

Duration: Economic cycles can last from a few months to several years, while market cycles can be shorter, ranging from weeks to months or even a year.

Causes: Economic cycles are driven by macroeconomic factors, such as demand and supply, while markets are influenced by microeconomic factors, such as investor and market sentiment.

Implications: Economic cycles have a broader impact on the economy as a whole as it impacts employment, income, and prices, while market cycles primarily impact financial markets and overall investor returns.

The four stages of the Economic Cycle.

Economic cycles refer to the fluctuations between periods of economic expansion and contraction. Several factors influence the economic cycle, with one of the most important being monetary policy, i.e., the rise or reduction in interest rates.

The key drivers include:

– Gross Domestic Product (GDP): This represents the total value of goods and services produced within a country.

– Interest Rates: This denotes the rate at which banks lend and borrow money. These rates impact borrowing and spending habits, with businesses being affected as borrowing costs increase.

– Employment: This refers to the number of people employed in the workforce. Economic cycles can lead to rises in unemployment.

– Consumer Spending: This significantly impacts economic activity and refers to the amount of money spent by households on goods and services. If rates rise, it squeezes household spending.

– Global Economy: External factors such as trade, exchange rates, and economic policies can impact overall activity.

– Inflation Rate: This signifies the rising cost of products and services within the economy, including the rise in fuel, utilities, and the overall cost of living.

There are four stages of economic cycles: expansion, peak, contraction, and trough. Interest rates are the main driver that impacts economic activity. Monetary policy not only influences household spending but also affects companies that borrow money.

When rates are low, businesses often thrive because the cost of capital is lower, and servicing debt is affordable, which positively impacts the bottom line. Conversely, when rates rise, the cost of capital increases, and servicing debt (interest repayments) leads to more outflows for companies.

Lower rates have been one of the driving forces of the economic boom over the past decade, which is why there is currently (in 2024) so much focus on monetary policy moving forward. The central bank becomes a key player in impacting market cycles.

Expansion

Expansion, often called a “Bull Market,” refers to the period of economic growth characterised by widespread opportunity and optimistic outlooks. Economic expansion occurs when GDP, employment, and household spending all experience positive growth. Businesses benefit from this momentum, leading to increased demand, business activity, and profits. Asset prices, such as stocks and real estate, also begin to rise during expansion. Investor confidence and risk appetite also increase, while interest rates typically decrease to encourage borrowing and consumer spending. All of these factors contribute to fuelling the economy during the expansion phase, creating a state of “euphoria” in both economic and market cycles.

Peak

The peak or “top of the cycle” is where the highest point of economic and market activity occurs. Prices and production reach the maximum level. Optimism is at its highest during the peak cycle. Investor and market sentiment pushes valuations of property, stocks and commodities through the roof. The price of stocks in particular moves beyond historical averages. Speculative behaviour begins to enter the economy. During this period monetary policy may be tightened and central banks step in with rate hikes to try and curb the euphoria. This maximum capacity can lead to a Market correction.

Contraction

Once economic growth hits the peak, it recedes into the contraction phase: Higher interest rates, inflation, demand tapers off and there is often excess supply. Out of contractions, recessions and depressions (bear markets) can be the result. The economy slows down with indicators such as GDP growth, employment and corporate profits being impacted. Consumer spending declines, and investment into business halts. Asset prices fall and suffer price corrections. Investors flock to safer investment classes pushing other asset classes down further.

There is more fear in investor sentiment and the once bullish attitude turns bearish. This is where the value hunters come out to play and thrive. As a response to the contraction phase, monetary and fiscal policy may enter to reignite and protect the downturn as Governments look to stimulate the economy using a range of tactics.

Trough

The trough is the lowest point of economic and market conditions, the doom and gloom financial media articles are rampant. The economy hits rock bottom. From here the cycle begins again, the birth of a new recovery and a rebound slowly plays out. As inflation and GDP start to stabilise, investor sentiment turns the tide and starts to warm up again. Periods of pessimism are pushed aside for new optimism and growth outlooks. Asset prices are undervalued and become attractive investment opportunities. Governments play a big role in reigniting and stimulating the economy.

Whether it is lower rates, stimulus packages, or favourable fiscal policies, all aimed at encouraging more activity within the economy. The recovery is slow, and the economic and market outlook returns to positive. With this renewed outlook comes the momentum that pulls the trough cycle back into a new expansion cycle.

The four stages of the Market Cycle.

Market cycles are closely tied to economic cycles, although they are influenced by different factors. Investors often rely on economic activity to guide their investment decisions during market cycles.

Several factors impact market cycles. The availability of capital in different markets can constrain businesses and lead to a decrease in the number of companies going public. In commodity-driven industries, the cost of materials can create boom-to-bust cycles in the market. Additionally, interest rates and monetary policy can affect how companies borrow capital, potentially leading to shifts in the market cycle. The cost of servicing interest repayments for companies with substantial borrowings is a significant driver of market cycles.

For example, consider companies that previously borrowed at a 1.5% interest rate. If their repayments have increased nearly threefold to 5% or higher, this can significantly impact their cash flow, putting a strain on their ability to fund other operational and growth areas.

Market cycles are also heavily influenced by supply and demand dynamics across various industries. Entire sectors can be reliant on the broader economic cycle. A slowdown in consumer spending, for instance, can affect non-essential companies as consumers become more budget-conscious, leading to cyclicality in certain industries.

Disruptions in industries, whether due to technological advancements, changes in government policies, or the removal of barriers to global trade, can also significantly impact market cycles.

Accumulation Phase

The accumulation phase works alongside the economic expansion phase. Investor optimism is returning, and the “bear market” looks over although not out of the clear yet. There is a lot of sideways action, no big movers, a slow trickling in of growing sentiment. There are bargains around, and a lot of value as stock prices are still depressed. Certain industries will be out of favour. There is still a lot of scepticism but to wise, patient long-term investors, cash starts to be deployed.

Mark-Up Phase

During the mark-up phase investor sentiment becomes positive and exuberance returns. This coincides with the economic cycle starting to rise near a peak. There is often an upward trend in markets and momentum along with volume increases as investors flock in. Valuations increase and cross over from value into overvalued levels. This is the proverbial “Bull Run”. Investors and markets all unanimously decide this is the bottom now and start driving the rise. All those who brought in the accumulation phase watch the bargains rise in value and along with it their returns. The break-out turns into euphoria. Greed and FOMO start to play a big role in this phase.

Distribution Phase

This is the top of the bull run in market cycles. The excitement leads to overvalued prices as they are pushed sky-high. Many investors are left holding the bag, caused by FOMO. Prices no longer move up, and volume disappears. A sell-off can be triggered by anything at any time. The distribution phase has early buyers in the accumulation phase offloading to latecomers. Market fundamentals are often thrown out in this stage as investors look to “Get in” on the bull run, often too late. Stocks and markets have gone on the set new highs, and this starts to slow. Overconfidence and an array of emotions play a big role in this phase.

Mark-Down Phase

The final phase is the markdown, decline or contraction. This phase sees stock prices fall and remain suppressed. There are not a lot of buyers to soak up the large selloffs. The optimism turns into pessimism, and this causes an even bigger sell-off. Prices and values fall, confidence slows, and the sentiment goes back to negative. This is the trough phase or “bear market”. This is where large losses can occur, as investors look to buy cheap stocks only to have them go down further to rock bottom. The decline can happen suddenly and unexpectedly.

Why learn Boom-to-Bust Cycles?

Understanding and leveraging market cycles from an investment perspective is not overly complex. It involves identifying the cycle and then determining which companies will benefit or suffer during each phase. Although cycles are short-term oriented, understanding them requires a long-term view.

Being prepared for changes in cycles is essential. You don’t need to perfectly predict the changes or make accurate forecasts to take advantage of cycles. Recognizing when markets reach their peaks can prevent you from making hasty investments. Understanding troughs can provide you with the opportunity to invest when market conditions are at their worst, which is often the best time to buy great companies at lower prices.

Investors can comprehend these boom and bust cycles and devise strategies to maximize opportunities and reduce downside risk when the cycle changes. The goal is not to guess, but to use informed decision-making based on a thorough understanding of market factors.

For example, if interest rates continue to rise, small-cap businesses relying on debt may suffer. In this case, you might consider selling companies with over-leveraged balance sheets in advance, anticipating that they will be strained.

Similarly, if an industry such as retail is impacted by declining consumer spending due to increased inflation, you can look for bargains in that industry from high-quality companies while patiently waiting for consumer spending to recover.

The nature of cycles ensures that they always come around. Buying sound companies based on the right fundamentals to begin with is key. I use cycles to anticipate how economic factors will affect the market. Whether it’s a boom in commodities driving prices high or a slowdown in certain areas, investors should always consider how this will impact businesses.

The key to navigating Market cycles?

Understanding the Economic and Market cycle can help you prepare for changes in the economy. Being prepared for all weather conditions is a part of long-term investing. By being aware of each of the cycles you can minimise the impact that downturns have on your portfolio. Moving capital around based on a strong understanding of each phase can safeguard your capital. You may have heard investors say, “I’m going to powder”. This means they are going to cash or safer asset classes.

A lot of investors have different strategies for different market conditions. I also utilise a similar approach. In bull markets, a lot of investors make money by simply participating. I want to buy into growth but always at reasonable prices. “Never chase the price, let it come to me” is my motto. I don’t think in terms of “Missing out”, investing is like a sushi train, if you miss the teriyaki this turn, it’ll be back around again.

By understanding cycles, investors can identify growth opportunities. If the markets have been in a prolonged downturn and the sun is about to shine, thinking ahead to what companies and industries will benefit can help discover strong growth prospects.

This approach can help you exit certain industries or companies early, thus avoiding significant corrections. Alternatively, it might lead you to adopt a contrarian approach, buying after a correction has occurred while patiently waiting for the next cycle. Patience is crucial in all of this.

My Approach to Economic and Market Cycles as an Investor:

Stay informed: Keep track of economic indicators such as GDP, interest rates, and employment rates to understand the current cycle stage.

Diversify your portfolio: Spread your investments across different asset classes, sectors, and geographic regions to minimize risk.

Adjust your strategy: During contractions, consider investing in companies that thrive during recessions, such as utilities, consumer staples, and healthcare. During expansions, focus on growth-oriented stocks.

Maintain discipline: Avoid emotional decisions based on market fluctuations. Stick to your long-term investment plan and avoid impulsive actions.

Be prepared for surprises: Economic cycles can be unpredictable, so be prepared for unexpected events and adjust your strategy accordingly.

Investors need to have a good idea of how certain asset classes behave in different market cycles. When one asset class is in favour another one is out. When markets are tanking, investors flock out of small-caps as they are deemed to be higher risk. They then flock to safer alternatives such as bonds. Understanding how the asset classes correlate to cycles is about constructing your portfolio to perform during a variety of market conditions.

Guessing the cycles is pointless. What you are trying to do is understand the indicators as mentioned in each of the phases. You will never get the timing right; you will either be too early or too late for a cycle. Depending on the phase, this can be good or bad. I’d rather sell out early before the peak sets in and come to the party a little late in the trough waiting for signs the bottom is truly near the bottom.

The indicators can provide signs that can help you move between various asset classes to prepare and plan for each phase.

The Psychology of Market Cycles.

Understanding market and economic cycles is crucial for improving the behavioural edge that individual investors need to succeed. By being mentally aware of the nature of cycles, it can help manage emotions and ultimately affect investment decisions. Emotions play a significant role in long-term returns. Recognising the natural flow of how markets move can reduce anxiety during downturns and help develop the patience and mindset needed to make sound decisions.

Being cognizant of market cycles can help create a strategy and ensure that portfolio diversification is executed to mitigate market fluctuations. Stability is crucial, and establishing a diversified portfolio can help protect against downside risks when the market takes a turn.

It’s essential to manage emotions between cycles to stay the course. Failing to do so can lead to panic selling or missing opportunities due to fear of loss, which can impact long-term financial returns. Equipping yourself with knowledge of these cycles can prepare investors to understand, interpret, and make strategic decisions under all market conditions.

Understanding market cycles has helped me stay steady during market turbulence and allowed me to capitalize on different cycles and make calculated bets during downturns. It has also taught me the importance of proper diversification and being prepared for anything, as investing involves continuous learning and adaptation.

This time it will be different is not a strategy. The nature of cycles is guaranteed. Markets won’t grow to the sky for too long and when they fall, it’s a matter of when NOT IF they rise again. Planning for the best and preparing for the worst is a prudent investment strategy to pursue.

I believe all investors would benefit from understanding cycles, whether to gain profit or to at least prepare them mentally for the turbulence and volatility markets bring.

In Summary…

The concept of investing around market cycles is not solely about developing a strategy tied to market cycle timing, as it would be difficult to implement consistently. The signals of cycles are often unclear, and determining the start and end of each phase can be even more challenging. Therefore, it’s about establishing a solid investment strategy that can be applied across most cycles, seizing opportunities, and incorporating risk mitigation tactics.

Understanding the cycles can provide investors with valuable insights into what may happen next, as they tend to be repetitive in nature.

I don’t make major moves solely based on market cycles. Instead, I evaluate my current investment allocations and consider where to allocate more capital to take advantage of potential opportunities. I primarily invest in small-cap companies. During economic and market downturns, contractions, and sell-offs, I actively look for promising small businesses that are high in quality but have been oversold.

These businesses often experience significant rebounds when the market cycle turns and investor sentiment improves. I’ve observed this pattern over the past 15 years. During periods of economic slowdown, fear prompts the withdrawal of capital from perceived high-risk asset classes, such as small caps. This overselling drives down the value of good companies significantly.

This situation attracts value investors and long-term small-cap quality investors. Momentum eventually returns, investor sentiment improves, the cycle reverses, and small-caps appreciate to overvalued levels, thus repeating the cycle.

Understanding the cycles and contemplating the flow of capital offers a contrarian approach to investing. I continuously seek to answer the question when I feel we are in an accumulation phase:

Where will the capital or smart money flow next?