October 30, 2018

What are market cycles?

A man swipes on his mobile phone while holding what looks like a credit card. A man swipes on his mobile phone while holding what looks like a credit card.

There is a familiar saying about life containing two certainties: death and taxes. Experienced investors might wish to add a third item to that list: the certainty that markets change. Just like seasons, markets move through stages of growth, slowing down and speeding up. Unfortunately, the timing of those cycles are unpredictable. In the summer of 2018, U.S. stock marketsOpens a new website in a new window set records with their longest recorded “bull market,” which is defined as period of rising prices. This is a perfect example of market cycles in action.

Market swings can be unnerving when it comes to your money. But if you understand why markets move up and down, it should be easier to focus on the long-term. Because while stock markets rise and fall during specific periods, history shows that the growth trajectory over time is up.

Why do markets cycle?

The basic argument for why markets rise is as follows: as the number of people on Earth grows and technology improves, workers and companies become more efficient and can produce more. As the value of goods and services we produce grows, so does the value of the companies that make up the world’s economies. And that’s what stock prices are – a reflection of the underlying value of companies they represent.

In 2016, American investing sage Warren Buffett wrote in his annual note to investors: “U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue.”

But while the long-term trend reflects rising stock prices, that doesn’t mean there won’t be dips along the way. Plenty of factors can cause stock prices to fall – maybe the economy is faltering, or there is a global shortage of a key commodity like oil. Also, investors can misjudge the value of companies and how profitable they will be in the future. You may have heard the phrase “stock market bubble.” This is when investors rush to buy stocks and bid up prices beyond what the companies are worth. When this bubble bursts, stock prices fall.

What is a bull market?

A bull market refers to a period when stock prices rise continuously. A good example is how stocks in the U.S. rose steadily after the spring of 2009. It is important to note that both individual stock prices and the market have at times fallen in value during this period. But the overall trend is a long upward climb.

Many people use the term “bull market” as a general reference to strong and rising markets. The most common technical definition is when stock prices rise over 20% during a specific period without dropping an equivalent amount. (For example, even if the market fell 11% during this period, as long as prices rebounded and kept rising it wouldn’t end the bull market.)

During this “bullish” period in the market cycle, optimism and confidence on the part of investors can turn into what is sometimes called “irrational exuberance.” This can lead to people abandoning carefully planned, long-term strategies and taking on more investment risk by buying stocks when markets are peaking.

Rising stock markets often coincide with increasing corporate profits, a growing economy, higher wages and lower unemployment. But this is not always the case.

What is a bear market?

The opposite of a bull market is a bear market. When most people think of bear markets, they think of a sustained downward fall in prices. As for the technical definition, we commonly define bear markets as occurring when stocks fall 20% or more without rising the equivalent amount.

Sometimes, falling prices can manifest into near-panic. Some people make investment decisions based on emotions instead of facts. Investors often sell otherwise “quality” stocks at low prices. For example, a company with a sound business model and smart management may see its stock price fall alongside the market, but not because anything has changed at the company. Investors might be tempted to sell quality stocks or mutual funds instead of holding out for the long term.

Finally, a bear market is not to be confused with what is often called a stock market crash. This is a term used to describe headline-grabbing plunges in the market that occur over a day or two. Bear markets are a longer, drawn-out fall in prices.

How long do market cycles last?

If only we knew the precise answer to this question we’d be very rich people. A full market cycle is commonly defined as the period between two highs. In other words, a bear market and then a bull market. For reference, U.S. stocks were seen to be in a bear market between roughly the years 2000 to 2009.

Investors sometimes pursue strategies designed to profit from market cycles by buying or selling stocks just before they expect the cycle to change direction. But that involves risk. As we mentioned, the exact timing of when market cycles change isn’t known. What is known, however, is that the historical trend shows continually rising prices. Stock markets will fall, but the historical evidence shows they eventually rise higher. Therefore, a well-planned, long-term strategy can be so important in helping to keep you focused on your investing goals.

This information is general in nature, and is intended for informational purposes only. For specific situations you should consult the appropriate legal, accounting or tax advisor.

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