In short
- The economy and the stock market move in waves. These waves are called cycles.
- A cycle has four phases: expansion, peak, contraction and trough.
- Sectors do not always behave the same way in each phase. This is a general picture, not a fixed rule.
- You only know which phase you were in afterwards. That makes timing very hard.
- You can influence costs, diversification, time horizon and rebalancing.
What is a market cycle?
The economy does not grow in a straight line. There are periods of growth and periods of decline. Share prices often follow that pattern, but not exactly. Prices can move before economic figures change, because investors look ahead. So the economy and the stock market are not always in step.
A cycle has no fixed length. Some last a few years, others much longer. There is no calendar you can rely on.
The four phases
- Expansion. Companies earn more, jobs are added and people spend more. Prices often rise, but not every day.
- Peak. Growth slows. Prices and interest rates may be high. Investors are often optimistic. You usually only recognise a peak afterwards.
- Contraction. Companies earn less and the economy cools. Prices often fall, sometimes sharply. A long fall is also called a bear market.
- Trough. The economy is at a low point. The bad news is known. Recovery can begin, but again you only know later.
How do sectors behave?
Sectors react differently to the cycle. These are general patterns from the past. In practice they often differ.
- Cyclical sectors such as industry, travel and luxury goods depend heavily on how much people and companies spend. They often move more with the economy.
- Defensive sectors such as food, healthcare and utilities supply things people keep buying. Their results are usually steadier. They can fall too.
- Interest-sensitive areas include banks, property and growth companies. A rate change can affect their prices.
Read more in sector rotation. This is a method of trying to switch between sectors. It requires good timing, which turns out to be hard.
Why timing is so hard
- You see the phase only afterwards. Economic data arrives late and is revised later.
- The market looks ahead. Prices can rise while the news is still bad, and the other way round.
- You can be wrong twice. If you leave the market you also have to get back in on time. Missing the best days costs returns.
- Emotions work against you. Fear during falls and enthusiasm during rises often lead to buying high and selling low.
- Forecasts are often wrong. Even professional analysts frequently miss.
This does not mean cycles do not exist. It means they are hard to use to outsmart the market.
What can you influence?
You cannot steer the market. Several things are in your hands.
Costs
Every transaction, management fee and currency spread costs money. Over a long period small amounts add up. Compare the costs of a broker carefully.
Diversification
Spread your money across more companies, sectors and regions. Then one poor choice hurts less. Diversification does not remove risk, but it makes it smaller. Read more in portfolio basics and diversification or about ETFs.
Time horizon
When will you need the money? Money you need in five years calls for a different approach than money for thirty years. The shorter your horizon, the greater the chance you have to sell during a trough.
Rebalancing
Over time the split in your portfolio drifts. If one part rises strongly it becomes a larger share than you wanted. Returning now and then to your original split keeps risk at the level you chose. Do this by a fixed rule, not by feel.
What can you do with this?
Use cycles to understand what is happening, not to predict. Choose an approach that can withstand a disappointing period. Write down in advance when and why you will rebalance.
This article is educational and not investment advice. Investing involves risk and you may lose some or all of your investment. Past performance is no guarantee of future results.