Like winter, spring, summer and fall… the stock market cycles. Now if you are aware of this phenomenon, you can better prepare your investments to reflect this reality. Being unaware of stock market cycles, on the other hand, can make you panic when things don’t go your way.
One of the most important concepts about the stock market is this feature of moving in cycles. Like the seasons that fluctuate repeatedly, the stock market moves between periods of extreme optimism and pessimism. This is where the terms bear and bull market originate from.
The interesting thing about strong bear or bull markets is that they aren’t readily apparent until after the fact. While general prosperity or low stock market returns are occurring, most investors are consumed with issues inside the current season, unaware that a new season might be and often is just around the corner.
This is one of the reasons why being a contrarian is so profitable. It’s also a factor in why value investing works so well. Value investing depends on investor sentiment and emotions wildly mis-valuing securities beyond its logical value. The difference of undervaluation becomes the margin of safety that value investors chase.
There’s two ways to look at the stock market. One is a very black and white approach. Either you buy a stock and it makes you money or loses you money. This is a very frustrating mindset to have, because you have no control over the situation. Anything can and does happen in the markets, and you’re just hoping that you come out ahead this time. It’s a short term and limited approach.
The other way is to recognize that the stock market moves like the seasons. Other than bankruptcy, nothing is permanent and things are changing all the time. Instead of trying to directly profit from our trades, you’re trying to hold for the long term and generally buy companies that are undervalued. This allows you to hold through less advantageous times and see opportunities where others don’t.
One glance at any stock chart will show you how much more the stock price fluctuates than the actual value of the business does. The ability to identify this value and capitalize on it is a major part of finding success.
Another major key to success is staying conscious of what season the market is in and making investment decisions based on this. Let’s examine some key characteristics behind the 4 seasons of the stock market.
Winter: This is the cold chill of a bear market. Periods such as this are often marked with high volatility and company bankruptcies. Sometimes you’ll see financial panic and bank runs, and people often say “this time is the end of the world.”
Of course, anyone paying attention would say that’s ridiculous. The market won’t be in a permanent bear market no matter how bad things get, in the same way that the world won’t freeze over because of a bad winter storm.
Contrary to popular belief, this will be the best time to buy stocks. The media will be filled with reports and studies showing how bad stocks are as investments. This is because they are cherry picking the time period, and using the events to manufacture fear and attract clicks and attention.
It can be hard to buy stocks during this time, particularly because seemingly better opportunities are out there. For example, when interest rates spike and stock prices drop, the interest rate for a CD or bond might be temporarily much higher than the average yearly stock market return you seek.
There was a time 30 years ago when you could get 9% interest on your money outside of the stock market, and so many people didn’t buy stocks. This kept stocks low for quite some time, but the investors who patiently resisted this temptation were handsomely rewarded.
Spring: This is the time between the bear and bull market. The brutal cold of economic recession, unemployment, and general negativity is starting to lift.
Keep in mind that there won’t be a sudden announcement of this new season of the stock market. If you’re following the media, you’ll see that they’re usually a season behind. Economic reporting, outside of unreliable forecasts, is done in the past tense.
This time period presents some of the best opportunities for investing in stocks. Share prices are usually suppressed, allowing for many big quality blue chip companies to be purchased at a steep discount. You’ll start to see the recovery reflecting first in the earnings, and the share price usually follows.
Understand that it’s always darkest before the dawn, and if you’ve struggled through winter remember that spring and summer are just around the corner.
Summer: After several years of recovery comes summer, the strongest part of the bull market. This is when the media begins to recognize stocks as once again quality investments. Blue chips preform quite strongly in this period. New emerging industries tend to spring up during these periods and even rise to bubble levels, such as biotech in the most recent bull.
Investing during this time mostly requires going along for the ride. You can’t just buy any stock and expect it to go up like you might’ve been able to in winter, but you can feel confident that many stocks will continue to rise for the short and even medium term.
Fall: This season marks the end of the bull market. The end of a bull market is easy to spot, but impossible to time. During the end of a bull market, you’ll see lots of IPOs and mergers and acquisitions. Founders of companies desperately try to cash in before it’s too late, while companies increasingly squire and merge with other companies as they start struggling to continue the torrid growth of summer.
This is when you want to be extremely picky with you investments. Search for value and don’t settle with overpaying for stocks. By far, this season is the trickiest to invest in. By searching deeper for value you’ll inevitably come across lower quality businesses. Have the discernment to avoid those stocks while still buying discounted stocks. If you’re struggling with this, my book is centered on this single concept.
Caution: By no means am I advocating you try to time the market and jump into winter and out of fall. You won’t be able to do it. Unlike real weather, there aren’t definite signals for the end of seasons in the stock market.
So, make sure you are dollar cost averaging with your investments. Use this knowledge of seasons to assist you with picking what kinds of investments you want to make, but stay consistent with the amount. This is the proven way to win in the long term with your investing.
Examples from the Past
You need to understand that stock market cycles are influenced by demographics and technology trends.
The “Roaring Twenties” was a time of abundant prosperity in the United States. Throughout the decade of the 1920s, the economy boomed. Fueled by new technologies such as the automobile, moving pictures, and the radio, optimism was at all time highs and it reflected in the stock market. Money flowed easily as interest rates were lowered and tax rates were cut.
The party couldn’t last forever, as many speculators and investors soon learned in the next decade.
You might be more familiar with the Great Depression, the decade of the 1930s that saw massive unemployment and an extreme bear market. The massive credit boom that brought the Roaring Twenties also contributed to the Great Depression.
The lower interest rates of the Roaring Twenties had encouraged borrowing both from individuals and corporations, which led to over-leverage. This loosened up a substantial amount of cash flow, which then flowed into assets like stocks and real estate. This then inflates capital goods prices, and you start to see inflation and asset price bubbles.
A boom driven by debt like this one is unsustainable, as Americans learned the hard way during the Great Depression. As interest rates climbed up from its bottoms, you saw less and less economic growth, which escalated into steep deflation. As the economy slows this rapidly, you see crashes in prices across all asset classes– stocks, real estate, capital goods, and even gold.
The asset bubbles turn into nightmares, and investors all around the country lose their shirts. The Austrian School of Economics, which contributed to economic ideas such as inflation and opportunity cost, teaches that the government’s attempts to prop up the economy after the 1929 stock market crash only made the Great Depression worse.
The Great Depression lasted until the mid 1940s, and things weren’t resolved until massive amounts of de-leveraging and corrections to inflated prices took place. People who retired during the Great Depression didn’t see as much wealth as those who retired during the Roaring Twenties. They weren’t prepared– and while I’m not trying to scare those of you about to retire– I do want to warn you of the possibilities.
Recall what I said about technology and demographics. As Harry Dent revealed in The Great Depression Ahead, massive spending and productivity trends from the populous baby boom generation helped contribute to the economic boom we saw in the 1990s. New technology innovations like the internet also contributed, and of course low interest rates and over-indebtedness.
The Market Never Learns
And of course, the 1990s dot com bubble popped as interest rates rose 6 times. We then saw a mini recession and a definite bear market, followed by a housing bubble in 2007 and subsequent crash, followed by another asset bubble we see today. When interest rates climb higher, as they inevitably will, what do you think will happen to the economy next?
Consider this as well. Dent reveals that the same baby boomer trend that contributed to the dot com boom will contribute to the next bear market. Baby boomer spending is expected to decrease in the coming years as this populous generation gets old and passes on. The biggest generation in the history of the world has contributed to a trend before, and it is more than likely they will contribute once more.
This doesn’t just apply to the general economy only. Think about this logic for a second. As the biggest generation we’ve ever seen gets old and passes on, they will leave behind houses once lived in. With many post graduates unable to find solid full time work after college, they are buying less and less houses.
There’s no way that the new graduate generation will be able to buy up all the houses left behind by the baby boomers. Those are double reinforcing trends working together, which will clearly lead to an increase in supply of houses. Let me ask you this, what happens to prices when supply increases? What about when demand decreases?
Prices drop when supply increases or demand decreases, so what do you think will happen to the real estate markets when these trends come true? How about when interest rates start to rise? What happens to assets classes like stocks and real estate? I hope you can see the similarities in the previous examples.
Here’s some other things you can do to prepare for the next bear market.
Like Benjamin Graham preaches in The Intelligent Investor, you should have anywhere from 25 – 75% of your portfolio in bonds. The percentage can be adjusted based on current economic conditions. While asset classes like stocks and real estate see their prices fluctuate all the time, bonds always pay you back the same amount as long as the company isn’t bankrupt.
Bond holders get their payments paid before stockholders do. Bond prices don’t fluctuate as long as you hold the bond to its maturity. You should always have bonds, and in case of a deflationary period this will serve you very well.
–Don’t buy inflated stocks!
This is really a requirement to be a wise investor, but you only see the vast benefits of this during a bear market. While stocks that have been inflated by foolish money crash to the ground during bad times, stocks that aren’t inflated see much less depreciation of their prices.
You should buy great companies at fair value prices anyways, but investors that don’t do this are the ones who lose fortunes during bear markets. Don’t get me wrong, you’ll see price depreciation as well, but it will be exponentially smaller than those who are buying the really expensive stocks. As the saying goes, “you can only see who isn’t wearing pants once the tide comes in.”
–If close to retirement, expose less of your portfolio to risk
Nobody knows when the next great depression or bear market will hit. I can present all the research and facts, but I can’t give you a definite time frame. No one can. So you need to be cautious and understand that something catastrophic can happen at any time.
Be prepared by shifting your portfolio to more bonds, tighten your trailing stops, and make sure you are free of debt. Diversify not just in stock sectors, but in asset and currency types as well.