Understanding and riding market cycles

Understanding and riding market cycles

NAV TL;DR

If you don’t have time to read through the whole article, you can check out our short version below.

  • The market moves in cycles which repeat – understanding the different phases can help investors make better investment decisions
  • Market cycles typically go through 5 stages – Trough, Recovery, Expansion, Peak and Contraction
  • Investors can always choose to adopt different investment strategies that does not require market-timing, such as using a Regular Savings Plan (RSP).

Financial markets go through cycles and progress through distinct phases before repeating the same patterns again. Understanding market cycles and having the right mix of assets at the right time will allow you to improve your potential gains while diversifying the risk. In this article, we will be sharing important phases of a market cycle that investors should pay attention to and the investments that you can make in the respective phases.

Generally, each market cycle lasts about 4 to 5 years and there are usually 5 stages within each cycle.

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1. Trough

The trough phase is when the economy hits an all-time low. In this phase, the growth rate of the economy is negative and there is a decline in supply and demand of goods and services. Revenue and profits for businesses decrease and there is a higher rate of unemployment.

In this stage of the cycle, stock valuations are undervalued or at discounted prices, thus it will be a good opportunity to invest in the stock market. Purchasing and holding these stocks until the market starts to turnaround allows you to buy them at bargain prices and potentially sell them at a much higher value in the future. Eventually, central banks will intervene by cutting interest rates to stimulate economic growth. This will signal that the economy is moving towards recovery and lead to an increase in stock prices.

Regardless of the investments you make, it must match your risk appetite and financial. Always do your homework and identify companies that have strong fundamentals - this will help you to pick securities that survive the bear market and rally when the economy recovers.

2. Recovery

As the economy begins to bounce back from the trough, it moves into the recovery phase. At this stage, governments ease their monetary policies and interest rates falls, resulting in a healthy environment for accelerated growth. Thus, the economy begins picking up where demand and supply increases. This will in turn facilitate the increase in production and employment. Overall market sentiments also start to shift from negative to neutral.

Additionally, as production increases, the demand for raw materials will also grow, leading to inflation. This presents a good opportunity for investors to invest in inflation-sensitive products such as the commodities market. If you are interested in investing in commodities such as precious metals and agricultural products, you can consider investing in commodity-tracking Exchange-Traded Funds (ETFs).

3. Expansion

During the expansion phase, the market has been stable for some time and economy is growing steadily, with a rise in employment, wages, supply, and demand for goods and services. In this period, profitability of businesses is healthy, credit growth is strong, investment is high, and the market experiences a bull run – recording higher lows and higher highs.

As market interest rates are low but will likely be increasing soon, you should consider reducing your bond holdings. As bond prices are peaking, you can sell your bonds on the secondary market and secure gains on the sale. When interest rates increase, bonds will become less attractive to investors and its sale price will decline.

4. Peak

As the economy continues to expand, it eventually hits its peak. Economic indicators such as the stock market, employment rate and gross domestic product (GDP) reaches their maximum limit and do not grow any further. The peak phase signals the turning point of economic growth, where growth turns from positive to negative.

At the peak of the market cycle, stock prices reach their highest points. At this point, stock prices are overvalued as large number of investors begin to jump on the stock market bandwagon. This causes inflation to occur, where commodities prices rise. Central banks will then step in by increasing interest rates to curb inflation. The increase in interest rates indicates that the expansion is coming to an end and stock prices will soon begin falling. Concurrently, commodity prices will rise.

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Therefore, in this stage, you should try to reduce your stock holdings and purchase more commodity-tracking ETFs as a replacement. For instance, during the financial crisis in 2008, stock prices plunged but commodities prices rallied. This would mean that an investor would have gained profits and prevented losses if he or she switched and invested in commodities ETFs instead of stocks.

5. Contraction/Recession

Immediately after the peak phase is the recession phase. In the recession phase, the economy contracts, and demand for goods and services decrease sharply. Corporate profits slumps and a credit crunch occurs. Furthermore, economic indicators would reflect a negative economic outlook.

As the economy contracts, all asset classes, such as equities, bonds, real estate and commodities suffer performance losses. As more people recognise that the economy is contracting and stock prices are declining, this will create fear amongst investors and trigger further panic selling.

During this period, it will be a good opportunity to invest in defensive stocks. Defensive stocks refer to shares of companies that enjoy a continuous and stable demand for their products. Examples of defensive stocks include shares of companies in the healthcare, utilities, and public transportation industries. Since there is a constant demand for their goods, defensive stocks maintain consistent and steady dividend pay-outs regardless of the performance of the overall stock market. Therefore, they would make stable investments during periods of economic recession.

Furthermore, it will be a good opportunity for investors to invest in bonds when the market contracts. When the economy begins contracting, central banks will reduce interest rates. This will encourage more investing and borrowing as the cost of finances become lower, which in turn, helps to stimulate economic growth. More importantly, the fixed interest rates that bonds pay become more attractive when interest rates are lowered. Hence, bond prices will increase.

Having said that, a long-term investor can choose to acquire shares of companies with strong fundamentals and adopt the buy-and-hold strategy. This will eliminate the need to switch amongst different asset classes. In addition, it will allow you to profit during the expansion and peak phases of the market cycle. However, you will need to be able to stomach large fluctuations in share prices and stock market corrections especially during economic downturns.

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Finding it tough to identify the phase we are currently in? You can always choose to adopt different investment strategies that do not require market-timing. For instance, investing in a Regular Savings Plan (RSP) such as the DBS Invest-Saver allows you to buy a fixed dollar amount of shares per month. This removes the hassle of timing the market by automating the entire process on repeat for you. With such a plan, you can take advantage of Dollar-Cost Averaging (DCA) as the average cost of your investment could potentially be lower versus a one-time, lump sum investment.

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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.

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