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Why You Need To Understand Market Cycles And The Swing Of The Pendulum

We often hear of the term “business cycle” in the news, and this relates to the boom-bust cycle which a capitalist economy goes through. In simple terms, a business cycle is one characterised by “booms” (expansions in gross domestic production (GDP), consumption and demand for products and services), as well as “busts” (contractions in GDP, a decline in propensity to consume and poorer demand for goods and services).

The stock market, which acts as a barometer of sentiment for businesses, also inevitably follows the business cycle. This article explores the idea of market cycles and how they can swing from one extreme to the other.

Howard Marks is the famous value investor who first wrote about market cycles and the “swing of the pendulum” in his first book “The Most Important Thing”. My colleague Lawrence wrote an article on Marks’ new book “Mastering The Market Cycle”, and he provides a good summary of what an economic cycle is.

The pendulum is essentially thought of as a measure of investors’ overall sentiments with regards to expectations of business prospects. When there is widespread optimism, valuations will be high and the pendulum swings to one extreme (euphoria). The converse happens when pessimism reigns – valuations will be at their nadir, and the pendulum would have swung to the other extreme (despondency).

While most investors are aware that these two extremes exist, what isn’t entirely clear is how correlated these two phenomena are. From experience, the stock market usually reacts in advance to a decline in actual business prospects. Therefore, the stock market is usually a leading indicator of things to come. Lagging indicators would include historical data and statistics such as GDP in the last quarter, consumer price indices and producer price indices.

The strange thing is that valuations do not tend to remain at the mid-point of the pendulum’s swing. As humans are emotional creatures, there is a tendency for valuations to either be too high or too low. This creates good opportunities for patient investors who understand companies well and also know the concept of margin of safety, which I had written about previously here . Market cycles such as bull markets and bear markets are thus a common feature of investing and these are patterns which will recur with some regularity, though their exact timing cannot be known in advance.

The investor should be equipped with knowledge of market cycles so that he can take advantage of low valuations to buy more, and to remain wary of high valuations and hold back from buying.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.