A market cycle refers to the trends or patterns that occur during different business environments.
During a cycle, some securities and asset classes may outperform others because their business models align with the current conditions for growth.
For this post, we’re going to talk mostly about stocks.
New market cycles can also form when a trend in a particular sector or industry develops in response to innovation, new products, or regulatory changes. These trends are considered ‘secular’ if short-term economic fluctuations are unlikely to have a lasting impact on long-term performance.
Tech shares are generally driven by secular trends, like cloud computing and 'software as a service' (SaaS).
It’s often hard to pinpoint a cycle until after the fact and they rarely have a clearly identifiable beginning or end point which can lead to confusion or controversy.
However, we believe that there is a benefit in pursuing investment strategies that aim to profit from them investing ahead of directional changes in a cycle.
The four stages of a market cycle
Each market cycle will generally have four distinct phases. These stages are accumulation, bull market, distribution, and bear market.
At each stage, different securities or asset classes will respond to market forces differently. As an example, during a market upswing, luxury goods tend to outperform because people are comfortable with spending more as they expect the market to continue in an upward direction.
In contrast, during a downturn, consumer staples like toothpaste and toilet paper tend to outperform because people don’t usually cut back on staples even if the market isn’t performing well.
What is a bull market?
Generally, we will say a bull market is when the price of stocks or other securities in an index rise at least 20% from a previous drop of 20%.
Bull markets are also characterised as a period of time during which stocks are rising. This usually indicates a strong economy, and high investor confidence. When investors are confident, the demand for stocks goes up, and as a result, markets generally trend upwards too.
What is a bear market?
A bear market is the opposite of a bull market, it is generally characterised as a period where stocks are falling.
Generally, we will say a bear market is when the prices of an index fall 20% or more from a previous high - this often occurs after a bull market.
During a bear market, investors are generally pessimistic, they don’t feel confident about the economy and may look to sell their investments and hold cash. This lack of investor demand can lead to market sell offs, and markets trending downwards.
When market prices become increasingly volatile (as we believe they have over most of 2018), you may think a bull market has transformed into a bear market. But we believe that it’s more likely that the small drop is a market correction and not a bear market.
What is a market correction?
Generally, we will say a market correction is when prices fall 10% or more from a previous high. Remember, we will generally say a bear market occurs when they drop 20% or more, which happened in the months following the financial crisis in 2008 and 2009, where some stocks lost nearly 50% of their value.
Corrections aren’t something for investors to panic about. Nor are bear markets, following the global financial crisis we’ve had one of the longest bull markets in history.
Market corrections and bear markets are both part of market cycles, so keep that in mind next time the markets drop and you feel the urge to sell. Check out our post on ten rules for not being dumb when the market goes down.
What is market volatility?
Broadly speaking, market volatility measures the rate of deviation away from an average price. Or in simple words, it’s the change in a security’s price over time.
In the case of investments like stocks, bonds, ETFs, etc. volatility is a factor used to gauge an asset’s value over a given time compared to an average or index. The more an asset’s price moves, the more volatile it is considered to be.
Generally, an individual stock will be more volatile than bonds, ETFs, and managed funds. That’s because an individual stock is issued by a single company, and many factors both inside and outside of a company can affect how it performs.
Volatility isn’t necessarily something to worry about but you should be aware of how much volatility (ie risk) you can handle personally – one of the worst things you can do for your investment returns is to sell when there is volatility and buy when times are good, or in other words buy at highs and sell at lows.
Why you should dollar-cost average through tough times
If you’re investing for the long-term and can handle the market volatility, one strategy to consider is dollar-cost averaging. It’s essentially putting aside a set amount and investing it regularly over time.
Even if you take small amounts and invest them every week or month, it can add up and compound interest can help your assets grow over the long-term.
Over time, the highs and lows of the stock market generally balance out. If so, you’ll get the averaging price over the period that you are dollar-cost averaging.
Of course, not everyone can handle the volatility. That’s okay, if you’re more risk averse you can diversify your investments into other asset classes which may reduce the volatility of your investment returns.