UNDERSTANDING MARKET CYCLES
Importance of Market Cycles in Investing
How to assess where we currently stand in the market cycle and adjust portfolio positions accordingly
In the relatively recent past, we have seen 2 major bubbles and their collapses — the Tech Bubble (2000) and the Housing Bubble (2007).
While locating bubbles seems easy in hindsight, many investors fall victim to the sudden collapse of markets, as were the cases during the Tech Bubble burst and The Great Recession. Similarly, many investors fail to seize the huge opportunities presented during extreme market panics, partly because they have been victim to the collapse leading up to such opportunities.
Is it possible to locate bubbles in real time so that we can take advantage of market collapses to maximize our investment returns?
I believe the answer is yes, as continuously implemented by the greatest investors of our time such as Warren Buffet and Howard Marks. The key is understanding how market cycles work by learning from historical cycles.
If we understand how market cycles work, learn to assess where we might be standing in the current cycle, and develop a disciplined investor mindset to position our portfolios accordingly, we can minimize losses during a market crash and seize the huge opportunities that arise.
Importance of Market Cycles
Howard Marks, the Co-Founder of OakTree Capital Management and one of the greatest investors who has been openly praised by Warren Buffett and Charlie Munger (which is quite rare), has written a fabulous book on understanding and assessing market cycles — Mastering the Market Cycle: Getting the Odds on Your Side.
In the introduction, Marks metions another book he had previously written — The Most Important Thing: Uncommon Sense for the Thoughtful Investor — in which he lays out 20 “most” important things to consider when investing. While there is no single “most” important factor that by itself determines an investor’s success, Marks expresses how he believes one of those 20 important things — “being attentive to cycles” — is of an especially paramount importance to have justified writing an entire book on just that topic: mastering the market cycle.
The key point of this book is that while accurate market timing and predictions are nearly impossible, it is definitely possible to get the odds of upside on your side by understanding how market cycles work, assessing where in the market cycle we currently stand, and adjusting your portfolio positions accordingly.
The following quote from the book highlights the importance of understanding market cycles:
“Most of the great investors I’ve known over the years have had an exceptional sense for how cycles work in general and where we stand in the current one. That sense permits them to do a superior job of positioning portfolios for what lies ahead.” — Howard Marks
In this post, I will walk you through on how market cycles work and how to assess where we may be standing in the current market cycle.
For those who want to diver deeper, I highly recommend reading the book by Howard Marks. What I will be writing below were influenced in large part by Howard Marks’s ideas on market cycles.
At the very end, I will let you know what I believe is the single most important sign you should look out for in the markets that can help you correctly assess the turning point in the market cycle.
Here we go!
The Rationale for Utilizing an Understanding of Market Cycles
Passive investing in S&P 500 Index is the best option for average investors
As Warren Buffett often recommends to the average people, simple passive investing in the S&P 500 Index — which requires close to no effort at all — tends to reward investors with quite astonishing average annual return of roughly 10% in the long term. With a lot of asset managers and hedge funds often underperforming the benchmark, passive long-term investing in the S&P 500 Index probably provides the best possible return-to-effort opportunity, and is really a great way to grow your wealth over time.
But to aim for a higher return, utilizing an understanding of market cycles may be the easiest option
However, if you are more serious into investing and are passionate about outperforming the benchmark in the long term, putting in the effort to understand how market cycles work can probably help you greatly.
An Analysis of 94-Year S&P 500 Returns Data
Let’s take a look at how the S&P 500 Index has performed historically over the past 94 years (from 1928 ~ 2021):
Over the 94 years, simple average annual return of the S&P 500 was 8% (7.97%). Note: this value is based on pure index price returns, not total returns.
What is very interesting from this long period of data is that while the long-term average return is 8%, the number of years during the 94-year period in which a particular year’s return was near this average rate were very few.
To get a sense of how few, let’s take a look at some range of returns. How many of the 94 years do you think had an annual return in the range of 5% ~ 11% (+-3% point from 8%)?
It is quite astonishing that only 8 out of the 94 years (less than 9% of the entire period) had an annual S&P 500 return of between 5% and 11%.
It becomes even more interesting if we expand the range even more. How many of the 94 years do you think had an annual return between 0% and 16% (+-8% point from 8%)?
That is less than 1/3 of the entire period, which means 2/3 of the 94-year period had an annual return of either below 0% or greater than 16%.
Let’s look at some more interesting data:
Of the 94 years, more than 2/3 had a positive return, more than 1/2 had a return greater than 10% and more than 1/4 had a return greater than 20%.
In contrast, only 1/3 had a negative return, around 1/5 had a return less than 10%, and only 6 out of 94 years had a return less than -20% (vs. 26 years of a return greater than +20%).
What We Can Take Away From This Analysis
What we can see from this historical data are 2 key observations:
- In any year, the S&P 500 return tends to deviate substantially from an expected long-term average return
- While the S&P 500 returns tend to deviate substantially, a large portion of those deviations tend to be to the upside rather than to the downside. More concretely, we had quite a many years with return greater than +20%, but very few with less than -20%. In other words, the S&P 500 Index returns distribution seems quite skewed to the upside!
Therefore, from these 2 observations, we can come up with the following:
- Long-term investing (rather than short-term trading) is in your favor because the market tends to rise in the long term at roughly 10% a year on average, even if you don’t do anything other than stay invested
- Short-term tendency of the market to deviate greatly from the average is also in your favor because a large portion of those deviations are to the upside rather than down
- If you don’t do anything about short-term swings and invest 100% passively in the long term, your average annual return will be equal to the roughly 10% average return of S&P 500
- But if you want to outperform the average, you need to be more active
- How? You can use an understanding of how market cycles work to minimize your losses in times of big market corrections — which tend to be not very often — and try to maximize your returns by taking advantage of such corrections
- The general tendency of the market is already in your favor. You just need to know how to improve the odds even more to your side
So, if you can locate bubbles and minimize losses during market panics by adjusting your portfolio positions accordingly with your understanding of market cycles and then more aggressively invest at lower price levels during market panics, your long-run investment performance can be greatly enhanced. This is the primary topic and goal of this article.
To see how even a very small improvement to your average annual return can greatly multiply your investment value over time, you can refer to a short article I’ve written on the power of compounding:
The Power of Compounding: The Greatest Wonder of Investing
How a 1% improvement to your average return can multi-fold your investment value in the long term
Now, let’s take a look at how market cycles work.
How Market Cycles Work
History shows that while the economy (and the market) tend to rise in the long term along a long-term average trend line, numerous factors work together to cause volatile swings in the shorter term as it continues along that trend line, forming cycles.
The swings in the markets often diverge from the trend line toward extreme levels both to the upside and to the downside as widespread euphoria and panic, respectively, influence the markets.
What is a Market Cycle?
Such tendency of the market to oscillate around the long-term trend line due to various factors in the shorter term creates swings in which the market rises faster than the long-term average rate in times of growth, often to extreme levels toward a peak, and also falls faster than the long-term average rate in times of contraction, often to extreme levels toward a bottom. An entire cycle of such up & down swings along the long-term trend line is what we call a market cycle.
Various Cycles Together Influence The Market Cycle
There are various categories of cycles that influence one another and also work in tandem in complex ways to influence the (stock) market cycle.
These cycles include:
Economic (Business) Cycles
- Long term trend represented by average GDP growth rate
- Short term swings in growth created by various factors including credit (money supply) and human psychology (e.g. wealth effect)
Corporate Profit Cycles
- Long term trend represented by average profit growth rate
- Short term swings in profits created in large part by degree of operating leverage (% fixed cost) & financial leverage (% debt), which can be affected by various factors including business prospects and psychology
- Long term trend represented by average level of credit availability
- Short term swings in credit availability & money supply influenced greatly by the general mood of the economy, market participants’ psychology, and very importantly, the central bank’s monetary policy (easing vs. tightening)
Putting all of these cycles together, we have The (Stock) Market Cycle
- Long term trend represented by average rate of stock market return
- Short term swings in market price affected by a complex inter-workings of various other cycles (including all of the above) and of course, psychological factors
The Effect of Psychology on the Degree of Market Swings
What if the market always perfectly and immediately reflected all of the fundamentals and the impacts of various events in the economy very calmly? There probably wouldn’t be much oscillations in the market; the market movements will much more closely follow the long term trend with peaks and bottoms that deviate much less from the long-term trend line.
If the market worked solely according to the efficient market hypothesis, there wouldn’t be meaningful profit opportunities unless you have the ability to accurately forecast future events that no one else can (which is close to impossible) or you use private information unavailable to the public (which is illegal). This would be the case if securities prices always perfectly reflected the fundamentals and events without “feelings”.
But we know from history, that such is not the case, because market participants’ emotions and various psychological factors in response to various market events almost always cause over-reactions beyond the real implications represented by the fundamentals.
Case Study: The Impact of the Pandemic in Early 2020
I would like to take the pandemic-induced market collapse of early 2020 as an example to illustrate how much market movement can be driven by psychological factors. I think it is a great example of how market can be driven to the extremes by a widespread panic; it’s also a very recent event that many people can relate to.
While the market collapse from the covid shock is something that understanding market cycles probably wouldn’t have helped much to avoid it, the degree of panic and the resulting degree of collapse, and also the new credit environment created by the Fed’s super-accomodatative monetary policy that followed the covid shock could have definitely been taken advantage of with a solid understanding of market cycles.
When the news of the effects of Covid-19 pandemic first hit the world in early 2020, if markets were perfectly rational, intricate forecasts would have been made on how much impact the pandemic would incur to the economy and to corporate profits, and the market would have reflected such forecasted impact and continued adjusting as forecasts were updated and eventually the actual impact was realized — nothing more, nothing less.
However, the pandemic entailed such a high degree of uncertainty, creating an enormous panic to sweep through the markets. Such widespread panic caused by the huge uncertainty resulted in the S&P 500 Index plunging more than 30% in just a single month from the top in mid Feb to the bottom in mid March.
So What Causes the Ups & Downs of Market Cycles?
While so many things affect the market in countless ways, putting together what we have seen so far, we can say that market cycles are largely formed by 2 general factors:
- The Quantitative — the fundamentals & events (e.g. GDP growth rate, unemployment rate, corporate profits, breakout of a war, …)
- The Qualitative — the psychology (e.g. wealth effect, FOMO, panics, …)
The quantitative factors (fundamentals) mostly drive the direction of the market in the cycle. If the econcomic indicators are strong and companies are expected to show strong and growing profits, for example, the market will accordingly be driven to the upside.
The qualitative factors (psychology) that usually arise in response to various changes in the fundamental factors or uncertainties tend to drive the market to extreme levels beyond what could be justified solely by the fundamentals.
When the market goes too far to an extreme level, both to the upside in bubbles and to the downside in panics, there must come a point when such extreme environment finally ends — nothing can go on forever. When almost everyone has chimed in on a FOMO spree during times of euphoria and the tide suddenly turns with no one else willing to buy at a higher price, the market will now turn to the downside. Likewise, when panic has spread so widely that almost everyone has sold off at extremely low market prices that there are no more sellers, the market will now turn back to the upside with even a little bit of hope of improvement in the economy.
Understanding this phenomenon of the tendency of the market to reach extreme levels in both the upside and the downside, we can get the odds of upside in our favor. If we take more caution in times of market euphoria to prepare for a potential turn to the downside, we can not only cash out at high prices made possible by the upside overshoot, but can also minimize losses during a market fall due to the reduced portfolio exposure, and also take advantage of the market’s downside overshoot by aggressively buying up stocks at bargain prices with the big cash positions we have prepared during market euphoria.
This is what is really meant by the famous quote “Be fearful when others are greedy & be greedy when others are fearful”. If you think the market is immersed in omnipresent FOMO and everyone seems to be panic buying (“others are greedy”), cash out your profits and slim down your portfolio by preparing a big cash position (“be fearful”). Likewise, after the tide has turned and everyone seems to be panic selling even at prices so cheap (“others are fearful”), use the cash you have accumulated to now aggressively buy up great stocks at bargain prices (“be greedy”).
By utilizing the understaning of market cycles and appropriate portfolio positioning, you may not be able to “sell at the head and buy at the foot”, but can have a great chance to “sell at the shoulders and buy at the knees”. That is what you should aim for.
Assessing Where We Are in the Current Market Cycle
So how can we determine where in the cycle we might be right now? Are we in a bubble? Are we in a panic? Or are we in a rather normal environment of growth or slowdown?
Since the market tends to rise in the long term and tend to have many more years of positive returns than negative, most investors probably would not have to be particularly concerned with trying to actively adjust portfolio positions for the majority of the investment horizon. In my view, investors will probably be better off staying invested in the stock market most of the time, taking advantage of the effect of compounding to grow your investment value over the long term.
Instead, what we should be worried about is assessing bubbles and panics, with the purpose of protecting our portfolio from the rather infrequently occurring market collapses.
- In a bubble, investors should turn cautious and cash out exisiting profits to get ready for a potential market collapse and adjust their portfolio positions by reducing market exposure and preparing more cash
- In a panic, investors should turn aggressive to take advantage of the low price levels by using the cash positions prepared during the bubble to load up on the many bargains that have become available
How Do We Know We Are In a Bubble?
In Mastering the Market Cycle, Howard Marks mentions how not every strong and long-lasting bull market is necessarily a bubble, noting the U.S. stock market of the time around which he wrote the book (around 2016). During those years, while the S&P 500 Index had been growing strongly and continuously for quite a long time and reaching new highs every year, there were no noticeable “FOMO” effects or serious maniac-like “stocks will rise forever” mantra surrounding the overall market.
What can really identify a market as a bubble is widespread euphoria marked by “price doesn’t matter”, “this time is different” & “this will go on forever” mantra. In addition, if you take a look around and can easily see some form of “absurdity” in the behavior by many market participants, you should start worrying that the market may be heading toward the final stage of a bubble to the brink of bursting. No one can know for sure how long such euphoria & absurdity will continue before bursting — such period of abnormal euphoria can indeed go on for an absurdly long time — but history has shown that there was not a time where such extremes have continued forever without ever facing impactful corrections.
Signs of Bubble from Past Bubbles
Let’s examine the 2 notable bubbles from our recent past and see what signs we could have identified as such “price doesn’t matter” mantra and absurdity in the market.
The Tech Bubble (late 1990s ~ 2000)
- A burst in the number of new & hot internet companies being started and going public with very high valuations because it was in the “internet” business
- Continued shoot up in the price of many internet companies with no meaningful revenue or profits (price doesn’t matter mantra)
- Everyone going crazy about anything that has the word “internet” in it
The Housing Bubble (mid 2000s ~ 2007)
- People with no income and no job taking excessive mortgages to own not just one, but several houses (sign of absurdity)
- Banks didn’t care to truly assess the underlying risks of all the complex financial derivative products created and sold with the ever-expanding housing market because everyone just kept buying them like maniacs, creating an enormous cash flow and profit party for the banks
- Even the major credit ratings institutions (S&P, Moody’s, and Fitch) all gave AAA ratings to securities with underlying subprime mortgages just because they were “diversified” and because the banks would otherwise “go to their competitor for the ratings” (sign of absurdity)
- Major leaders of the finance industry and even government figures like the Secretary of Treasury and even the Fed chair all assuring the market that “times are so good” and that “it’s hard to see a recession coming” even as the banks were immersed in the maniac-like sales of the mortgage derivatives
Signs of Bubble from the Current Market Cycle
Now, learning from these past bubbles, let’s see if we can identify signs of a bubble from our current market environment.
The 2nd Tech Bubble — Blockchain, Crypto, NFT, Metaverse, AI, EV, Mobile, Platforms, etc.(~early 2022)
- A burst in the number of new & hot blockchain/crypto/NFT/EV/platform companies being started and going public with very high valuations because they are “blockchain”, “NFT”, or “tech companies”
- A burst in the number of new & hot coin offerings and valuation of many coins going over tens of billions of dollars with most coin investors having no idea how exactly blockchain works or what the coins really are
- Continued shoot up in the price of most coins, NFTs, and tech companies with no meaningful revenue or profits (price doesn’t matter mantra)
- Coins that were created by some developers as a “joke” — e.g. Doge coin — and even those created as a joke on top of other jokes — e.g. Shiba Inu coin —being valued at tens of billions of dollars (sign of absurdity)
- Random selfies taken by a student in Indonesia being sold in total for $1 million after being made into NFTs, with the seller saying that he is happy to have earned a lot of money, but doesn’t understand why people would buy them at such high prices — https://www.businessinsider.com/indonesia-student-makes-a-million-selling-expressionless-selfies-as-nfts-2022-1 (sign of absurdity)
- Mainstream Wall Street and government institutions who have rejected the coins as “scam” just a couple years ago now accepting them as a new “asset class”, without any better understanding of the underlying technology or the future growth implications of the networks other than the fact that the coin prices have shot up absurdly
- Everyone going crazy about anything that has the word “blockchain”, “crypto”, “NFT”, “metaverse”, “AI”, “EV”, “growth” in it
Do you notice the similarity between the current market’s bubble signs to that of the tech bubble of 2000? In contrast, the signs seem quite different in the details when compared to the housing bubble of 2007.
This shows us that the details that lead up to a particular market bubble can be different for each market cycle, but the overall “theme” of such signs, as in the “price doesn’t matter” mantra and signs of “absurdity”, do repeat.
Therefore, it is important to understand how market cycles work and to train our ability to identify the signs of such “price doesn’t matter” mantra and “absurdity” in the market so that we can adjust our portfolio positions accordingly to take advantage of such market oscillations to increase our odds at achieving a better-than-average investment returns.
The Single Most Important Sign of the Market Turning Points
Identifying the thematic “signs of bubble” in the real market environment before the bubble actually pops may seem easy in hindsight or in theory, but can be really difficult to pull off in reality.
Thus, I would like to suggest a single concrete factor that you can use as “the sign” to alter your portfolio positions.
This single concrete factor is: the Fed’s monetary policy shift.
The Role of the Federal Reserve
The reason this can be such an effective sign to use as the mark for the market’s turning point and your portfolio positioning is that the Fed’s job is actually to assess the market cycles and implement appropriate monetary policies. In fact, the Fed’s two main purpose of existence is 1) to help the economy grow in times of slowdown and 2) to control the economy from overheating in times of expansion.
The Fed aims to fulfill these two main duties by monitoring the 1) unemployment rate and 2) inflation. When the Fed is more concerned with the unemployment rate being too high — an economic recession — it will shift toward dovish monetary policy to help boost the economy. When the Fed is more concerned with the inflation being too high —the economy overheating — it will shift toward hawkish monetary policy to cool down the economy.
The primary tools used by the Fed to accomplish its goals in either policy direction are 1) interest rate and 2) money supply. To aid economic growth, the Fed can lower interest rates and/or increase money supply. To prevent the economy from overheating, the Fed can raise interest rates and/or reduce money supply.
The Importance of Money Supply
I personally believe the single most important factor that affects the direction of our economy — expansion or slowdown — is the amount of money (and credit) supply available in the economy. If there is abundant money supply, people can easily borrow money at low interest rates and thus have more money to invest and spend, propping up investments and consumption and thus leading to economic growth. This creates a positive cycle of continued growth, expansion, and more spending. As the economy continues to grow, people will inceasingly feel wealthy and the rising wealth effect will further boost consumption and expansion, ultimately to unsustainable and extreme levels.
Now, when the economy seems to overheat in the form of low unemployment rate and rising inflation, the Fed will start to shift its policy direction to control the economy from going into extreme bubbles by raising rates and tightening money supply. What the Fed is really doing when its policy is in a tightening mode is intentionally trying to slow down the economy by reducing the money supply.
Thus, when the Fed shifts its monetary policy stance from being dovish to hawkish — or from easing to tightening — the Fed is essentially seeing the economy as in the process of being overheated. And when the Fed actually starts tightening the money supply, it means the economic growth will slow down at a minimum. If the Fed was a bit late in its policy shift, meaning the bubble was already created, the slowdown that would come from the combined effect of the Fed’s intentional policy to slow down the economy and the market’s psychological vulnerability that comes from asset prices falling from an environment where prices didn’t matter can create a widespread panic that would bring the markets down to the other end of the extremes, where again, price doesn’t matter, no matter how cheap.
So, if it seems difficult to identify signs of bubble in the market, look out for the Fed’s policy stance shift to make your adjustments in your market view and to your portfolio positioning.
Remember, don’t fight the Fed!
Invest in times of monetary support. Stay aside in times of monetary tightening.
BONUS: My Personal View of the Current Market Cycle (~2022)
I personally don’t consider the Covid-shock of early 2020 as a “recession” in the true meaning of an economic cycle. In fact, the Covid shock led the Fed to take super-dovish monetary policy due to huge uncertainty, but the economic shock turned out to be almost “fake”, with the fast development of vaccines and the unprecedented money supply helping the global economy rebound and grow at an unprecedented pace and leading to the formation of an extreme bubble with historic inflation levels.
I believe the current market cycle began in 2009~2010 in the aftermath of the Great Recession with the initiation of the zero-rate environment and QE by the Fed under Bernanke. Thus, with the current market expansion having continued for more than 12 years aided by the unprecedented zero-rate environment and the unlimited money supply, I believe the degree of the current market bubble to be enormous.
With such a big bubble, a 20% fall in S&P 500 from the all-time high after 12-years of continued growth is probably not a bottom. When a pure joke such as the Shiba Inu coin is still worth $6 Billion (as of June 5, 2022), we are probably nowhere near the bottom in this market cycle. The slowdown has indeed started, but for the market cycle to reach its downside extreme levels, there is probably a long, long way to go.
As with assessing the signs for a market bubble, we should look for extreme behaviors in a market panic. Take a look around. Does the current market seem to be in an extreme panic after the recent market corrections? How about compared to the Covid-crash during Feb~Mar 2020? Definitely not.
As long as the Fed stays course in its hawkish monetary policy stance, it would be very difficult for the economy to grow strongly and for the markets to continue rising. For such shifts to occur for the economy and the markets, I believe the Fed must first shift its policy stance to be accommodative again.
For a more in-depth analysis, you can refer to an article I have written on my views of the current macro environment (written in March, 2022):
- Mastering the Market Cycle: Getting the Odds on Your Side by Howard Marks
- S&P 500 Index annual return data from slickcharts.com