Sometimes it can seem like the stock market operates in a world of it’s own, totally disconnected from the real economy and the realities of world trade. However the stock market moves in cycles just like the wider economy and by understanding these cycles, investors can be better prepared for what the market will throw at them.
None of us know exactly when stocks will soar skywards or plunge back to earth, but what we can be sure of is that both will normally happen within the space of ten years or so. In just the last couple of years we have seen Australian stocks fall from over 6500 to near 3000, then in around six months rally back up near 5000. That’s quite a ride.
This might sound like a once in a lifetime event, but in fact it is just the stock market going though process of taking a lot of heat out of stocks, chopping us all down to size and then laying the groundwork for another bull market. Yes the correction has been the most severe most of us have seen, but it was a correction nonetheless.
In very simple terms the stock market generally moves from boom to gloom and back again. I know this might be obvious to many people, but it is amazing how many investors appear to forget this.
The happiest investing time for most of us is during the boom years. During the stock market boom cycle there seems to be money to be made everywhere and we all get caught up in the mood in some way. Investment bankers earning millions are on the covers of business magazines, colourful property developers jet around doing deals and rags to riches stories are in plentiful supply.
The boom cycle tempts people to take on more debt and expose themselves to more risk because it seems that the time has arrived to make money. Everyone from government leaders to sports car driving entrepreneurs are talking up the economy. Times are good.
In hindsight it is easy to spot when the market hit the top and the bubble was ready to burst. However the truth is none of us can accurately predict when this will happen, so the best course of action in my opinion is to simply be prepared for a correction to strike at almost any time. (in other words have a Plan B)
Regulators and central bankers can talk all they like about preventing market bubbles, but the fact is there is always one developing somewhere. Therefore I figure it is best not to be caught out, keep debt under control and expect to take an earnings hit at short notice.
In the good years I sell off some stocks that have done really well (then normally watch them go higher) and try not to get swept away by all the excitement, although I inevitably do to some extent.
This approach will not get me on the cover of any investing magazines but has so far kept the bills paid and helped me sleep at night even as the global economy dived towards the abyss. By my logic if you expect to suffer some losses from time to time and plan accordingly, then you will be better prepared when the good times come to an end for a while.
Eventually all bull markets come to and end (although we sometimes behave like they don’t) and when a major correction strikes the stock market enters a gloom cycle as company profits plunge, firms collapse and investors who have over extended themselves are wiped out.
Suddenly investment bankers are as popular grand final referees, property developers are selling off their sports cars and stories about former high fliers who have lost everything are the popular tales of the day. The further stocks fall, the more gloomy the mood becomes.
After a while there is even talk about money becoming worthless, the break down of civilisation and end of the world as we know it. These are all possibilities of course, but unlikely, and are simply an indicator that the stock market doom cycle is in full swing.
But just as stock markets tend to rise too fast and need to be pulled back, they also tend to fall too far. In 2008 we saw many weeks of panicked selling and in fact investors were still selling out of stocks up until March this year. Much of this selling was due to investors losing confidence or trying to cover over exposed positions and it appears now, that March was probably the point of maximum gloom this time around.
The interesting aspect of gloom cycles is that people start to believe that the economy or stock market will never recover. Many investors swing from being overly optimistic in a bull market to overly pessimistic in a downturn. Buying during the boom cycle and selling in the doom cycle is a well proven way to lose money very quickly.
Probably the hardest thing for investors to do during the doom cycle is to believe that their will be a recovery. This time around the market plunged so far that even the most optimistic of investors had their confidence shaken, but as we have seen over the last few months stocks did eventually recover.
It may take years for stocks to get near the levels seen in 2007 again, but it is likely that these levels will be reached again at some point.
As I have written before, the global financial crisis was a major economic & stock market correction but it was not Armageddon.
Yes billions of dollars have been lost and the global economy will be changed somewhat by the events of 2008, but the bankers will be back. Once growth returns to the world’s major economies all the harsh talk about reigning in financial institutions will be toned down and we will merrily work away at forming a new bubble.
Sadly there is no perfect way to deal with stock market cycles simply because they vary in nature and we can never be sure how long the cycles will last. The important thing is for investors to appreciate is that stocks will not keep rising year after year but conversely nor do they keep falling. Just as stock markets peak they also bottom out and although it is sometimes hard to believe, another boom cycle will come around again.
Remember that since 2003 we have had only 1 year of negative stock market returns in Australia. Yes 2008 was a shocking year for investors and the early part of 2009 was not very good either, but in the overall scheme of things one bad year in six is hardly bad odds. (and if we finish higher this year it will be one in seven)
Finally it is important to appreciate stock market cycles do not follow a nice smooth predictable path. The stock market could soar in the last quarter of this year or fall back if investors become concerned about the strength of the global economic recovery. The only thing certainty about stock market cycles is that we have them, let’s hope we all remember that next time stocks are heading towards new highs.