Investing Basics: Market Cycle

What is a Market Cycle?

Day turning to night, seasons changing from winter to summer are natural phenomena that occur with predictability. Similarly, the economy goes through a market cycle due to varies market events and situations. This phases in this cycle are commonly known as the Recovery, Expansion, Contraction and recession phases respectively.

While it is inevitable that some investors make a windfall, while others suffer huge losses due to market situation changes. The priority for a long-term investor is to accept the market volatility and make preparation accordingly to the investment portfolio.

Read About: Investment Portfolio

What causes volatility in the economy?

The financial market is an event-driven environment, constantly driven by conflicting factors that move it one direction or the other. Investor sentiments, foreign currency exchange rates, policies changes and politics all causes the market to react accordingly, sending valuation of assets up or down. A successful investor embraces the opportunities instead of the uncertainty in the economy.

What are the phases of the Market cycles?

Contraction

When the economy is running at full steam, companies valuation will increase as there is more demand from buyers than supply from the seller in the market. The peak of valuation occurs when profit taking starts and there are selling than buying in the market. This is a case of supply outpacing demand leading to a drop in valuation.

Outlook starts to go bad for the overall economy as consumer expectations are falling and there is overproduction in the economy. Liquidity starts to tighten and headcount starts to fall as companies profits take a beating. Investing in non-cyclical sector provides better returns as they not affected in a recession as much compared to the others.

What sector to invest: Consumer staples (near the beginning), Services, Telecommunication, Utilities

Recession

At this point in time, consumer sentiments and expectations are at the lowest point, companies valuation drops and liquidity in the economy is at rock bottom. GPD falls, Unemployment is at its highest and unprepared businesses end up in bankruptcy. Interest rates are at all time lowest as governments attempt to stimulate lending and increase liquidity into the economy.

Cash is king at this point in time as valuation is at its most attractive point. Investors will do well here investing in sectors that profit in a recovering economy

What sector to invest: Transport, Technology, Industrial

Recovery

After all the blood spilled in the streets, it is only a matter of time before what goes down comes up. The market is still bearish and valuation is at its most attractive point. For every seller in the market, there is a willing buyer to take up the sales, forming a support for the economy. Liquidity starts to loosen, unemployment falls and business starts to make a profit.

An investor will be better investing in sectors that profit the most when there is increasing liquidity and expansion in the market.

What sector to invest: Industrial, Raw Material, Energy, Consumer Discretionary

Expansion

This is the golden era where unemployment is at the lowest and businesses make the most profit as liquidity is at its highest. Price to earnings ratio (P/E) increases as the buyer outpace seller in the market. Valuation of companies starts to reach an all-time high or a new breakthrough. It is time to tread carefully towards the end of the expansionary phase for interest rates has already started to rise, and borrowing may prove difficult for distress businesses. What comes next is a contraction.

The investor will be better off investing in sectors that are not as heavily affected by the upcoming slowdown. Better to invest in the “boring” sectors, you do not want to bore the full impact when the market rally ends.

What sector to invest: Services, Utilities, Consumer Staples (nearing the end)

What to make out of the Market Cycles?

Just as it is impossible for a period of growth to continue indefinitely, a recession will also certainly lead to a recovery in time to come. Instead of aiming to time your entry into the market, stay invested prudently through a diversified investment portfolio.

Read About: Unit Trust Funds

The objective of a speculator is to stay ahead in the short term, while the objective of an investor is to build a suitable portfolio to consistently earn positive gains in the long term.

Read About: Effect of compounding returns

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