A Quick Guide to Market Cycles

Cycle positioning is one of the keys to investment success. You identify critical points in a market cycle and adjust your portfolio accordingly. If you get this right, chances of making significant profits are much greater. Great investors understood this, so should you.

Market Cycles in a Nutshell

Why do market move in cycles? “People,” explained Warren Buffett recently, “get smarter but they don’t get wiser. They don’t get more emotionally stable. All the conditions for extreme overvaluation or undervaluation absolutely exist, the way they did 50 years ago.” In other words,

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  • Bull/bear markets do not last forever. They interchange.
  • Each market cycle is unique. Calling the top/bottom it is very tricky.
  • Each cycle is (usually) led by different assets.
  • Risk is low at the bottom of the cycle and high at the top.

Easy enough. A lot of these are just plain common sense. The hardest part is putting these knowledge to work. Out of the market too early, regrets will swell on rallies. Overstayed the party, profits will vanish. Few get it right consistently. But that does not mean you should not try.

Five Steps to Enhance Your Portfolio Through Market Cycles

Know where we are now (roughly). The first step is to pinpoint the current market cycle.

  1. How long has the current market trend started? Is it long by historical standards?
  2. What about the economy? Is it doing badly or well or muddling through?
  3. What is the central bank trying to do? Accommodative or restrictive?

All you need is a rough guide to the Big Picture.

Look for warning signs. This is where your market knowledge comes in. I give three examples below:

  • Yield curve – One of the most reliable economic signals is the position of the yield curve – particularly, the inversion of the yield curve. Anytime you see an inversion of the yield curve, be prepared for a slowdown in the future.
  • Property bubble – Most economic cycles are accompanied by excesses in property because of the lag in supply. If you see a property bubble based on bad lending practices, be prepared for a credit crisis some time down the road.
  • Valuation of assets – If an asset is valued very highly (by historical standards), you know that the market psychology is very bullish. This is dangerous because of the cavalier attitude towards risk and leverage.

Protect your portfolio. Concentrate on survival over a market cycle.

  1. As the bull market runs, trail stock positions with stoploss orders – mental or actual.
  2. Have rules for exiting the market, either partially or fully.
  3. Do not be afraid to hold cash. Why? because you need cash to buy assets when they are ‘cheap’. You make your fortunes in a bear market by paying for assets far beneath their value.

Fine tune your system. Devise clear rules for buy/selling.

  1. Use new/52-week/26-week price highs as a buying guide.
  2. To sell, use stop-loss, indicators or simple 52-week lows.
  3. Make a Yearly Asset Allocation rule, eg, reduce/increase allocation based on the length/size of a market trend. Moving a few percentages into defensive positioning could increase the odds of outperformance over the long term.

The key here is not the rules – different people have different rules. It is your ability to follow them. I can not stress this enough. The best investors are rational, disciplined, and unemotional. If you find yourself easily swayed by the mob psychology – stay away from the screens.

Learn to be a contrarian. Navigating market cycles is about taking – unpopular – positions at the top and bottom of the market cycle. But this is really difficult because you are going against the crowd. If you find yourself unable to do so, use mechanical rules to help you. As John Templeton stressed:”To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.

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