The economy follows cycles of 4 successive phases: expansion, peak, contraction, and trough. The stock market is closely correlated to these phases in what is known as a stock market cycle.
Your investment strategy and the sectors that are most likely to perform well will vary depending on the phase of the stock market cycle.
What are Market Cycles ?
Market cycles are a succession of phenomena observed on the financial markets that are directly correlated to economic cycles, i.e. the state and evolution of a country's economic activity.
According to various theories, the economy does indeed follow cycles whose constituent events are always the same and recur in the same periods. Based on this statistical principle, it is therefore possible to predict the evolution of the economy of a country according to the stage of the cycle in which it is. By interdependence with the economic cycle, Market Cycles are also predictable.
The four phases of the Market Cycle
The Market Cycle follows the 4 phases of the economic cycle, namely:
- Expansion : a phase of rapid growth accompanied by rising interest rates and inflation.
- Overheating : the expansion reaches its peak and the growth rate becomes moderate. At this stage, interest rates rise even more because inflation is very high.
- Recession : interest rates, inflation and economic activity in general fall drastically.
- Economic recovery : interest rates are still falling, but the economy is picking up with a recovery in transactions and consumption.
- The economic recovery continues : growth rises, as do interest rates and inflation, until it reaches a certain point where the country is in an expansionary phase. The cycle starts again.
The duration of a Market Cycle
The average duration of a Market Cycle has been estimated at 7 years, including upward periods of about 5 years and a downward trend of about 2 years. These estimates are based on past observations, but there is no guarantee that they will apply in the future.
Which investment strategy to use according to Market Cycles
- The expansion phase is characterised by strong stock market rises and sharp corrections. The expansion can lead to overbought areas for stocks in sectors that are more sensitive to economic cycles.
- The overheating phase offers a final boost to prices. It is important to set stop orders in anticipation of a future decline, to sell some of the more volatile stocks and to move into the blue chips. At the end of the overheating period, the stochastic oscillator shows an oversold arrival for stocks in the most cyclically sensitive sectors.
- The recession phase is characterised by a sharp fall in the financial markets, or even a stock market crash, fuelled by the flight of investors observed at the end of the overheating (oversold) period. At this stage, it is best to wait for signals of a recovery before taking action.
- In the recovery phase: stocks and bonds rise. This period generally offers the best prospects for investors. This is the most successful stage of the stock market cycle. This is the best time to open margin accounts.
Sectors that are sensitive to market cycles
Caution : Some industries are more sensitive than others to economic and market cycles. Historically, these sectors include commodities, capital goods and consumer durables. Stocks in these sectors should be closely monitored.
In addition, professionals believe that :
- expansion periods offer good investment prospects in the energy and telecom sectors
- financial and technology sectors are more likely to be stable during a recession
- periods of recovery generally see investors turn to the commodity and industrial sectors
Finally, it is necessary to detect the sectors potentially caught in a speculative bubble, causing a stock market cycle with a specific duration, independently of the macroeconomy.
The Market Cycle triptych
To anticipate phase changes, you can use the “triptych method”, a series of 3 graphs superimposed on each other:
- The first chart represents the price of the asset over a so-called "operational" period, i.e. the period during which you are trading.
- The second graph represents the asset price over the so-called "umbrella" period : a period equal to 4 to 6 times the operational period.
- The third graph represents the asset price over the so-called "timing" period : a period equal to 1/5 of the operational period.
You can use moving averages to analyze these three charts.
- The analysis of the price over the operational period in relation to the umbrella period allows you to detect the current phase, to validate a trend and to make an appropriate decision (buy or sell).
- The analysis of the price over the operational period in relation to the timing period allows you to decide when you actually take action within the operational period.
For example, an operational period of one week leads to an umbrella period of 5 to 6 weeks. If the trends are the same over these two periods, you confirm a decision. By comparing the weekly price (operational period) with the daily price (timing period), you decide whether or not to take immediate action.
In short, the triptych is a two-step method of analysis that enables you to :
- make a decision
- take action when the time is right
Note : the stock market cycle triptych is always compiled with other indicators and other analyses, including stochastic indicators, P/E, and EPS.
In conclusion, while it is obvious that national economic cycles influence stock exchange trends, certain sectors follow their own cycle, in particular in case of speculative bubbles. We advise you to integrate the triptych of the stock market cycle in your analysis of a stock to confirm or deny a trend and to determine exactly when to take action.