Many novice investors are unaware that a market cycle exists, and many professional investors wish they had never heard of it. The market cycle is the natural peaks and troughs of the market as money moves in and out of the economy. The reason professional investors hate market cycles is because they are virtually impossible to predict. The vast array of contributing factors coupled with the effects of human psychology means that trying to predict the market is like trying to predict when a herd of buffalo will stampede.
Watch the KDM Market Cycles video below to find out more information.
Understanding the market cycle can be helpful in identifying why and how the market is currently performing. I am reluctant to say that understanding the market cycle will help you determine when to buy and sell. However, having the ability to understand market movements will be beneficial for identifying when it is NOT a good time to buy or sell.
The most important reason for understanding the market cycle is so you can maintain perspective and resist the urge to invest emotionally. Below you will discover the effects each section of the market cycle can have on a novice investor’s emotions. Through understanding this process and identifying these emotions, you should be able to maintain an objective outlook and therefore avoid costly, emotion-driven mistakes.
When the market is at its peak, individual investors are euphoric. Despite most asset classes and commodities being overpriced, investors will still be pouring money into the market to take advantage of the rapidly increasing values. To prevent a bubble from forming and to combat inflation, the Reserve Bank of Australia (RBA) may lift interest rates. This makes it more costly for investors to borrow money and as a result it may cool speculation. As money becomes more expensive to borrow, companies will begin to cut back on expenditure and reduce their debt in order to reduce their exposure to interest rates.
As interest rates increase, investors will become less inclined to borrow or invest and more inclined to leave their money in an interest-bearing account. This reduction in investment, coupled with a lower level of company expenditure, may force assets to fall in value. At this stage, many investors are in denial and refuse to sell up, especially if they have recently purchased an asset at inflated prices.
As a result of the market retraction, banks tighten the lending criteria and money becomes harder to come by. Investors, who were once in denial, now move into panic mode and start to rapidly sell off their assets. As money leaves the economy, companies start to downsize and lay off workers. The reduction in employment along with capitulation amongst investors leads to a low level of market participation and a further reduction in asset prices.
Inflation slows as a result of lower asset prices and companies lowering prices to increase demand in a flailing economy. With lower inflation, the RBA is able lowers interest rates and increase the supply of money. Savvy investors see the opportunity to purchase assets at deflated prices and therefore money moves back into the market. As asset prices start to grow, banks loosen their lending criteria. The number of investors returning to the market increases due to a combination of easier access to money and lower returns on cash holdings. Asset and commodity prices rise, optimism and cautious investors floods the market, and the economy enters another peak.
Adviser’s Tip: When the market is scared you should be bold; when the market is euphoric you should be cautious.