Panorama article

Four stages

The economic cycle has typically four phases:

=> early cycle

After a recession, the economy starts growing again. Consumption of goods and services improves, as so does the employment rate.

Financial markets slowly restart to move upward.

=> mid cycle and peak

Moving forward, growth accelerates. There is a healthy flow of money through the economy and unemployment moves lower, but inflation tends to emerge of by-product of rapid growth.

When economic growth reaches its fastest paces, we are at the peak in the cycle.

=> late cycle

After peak, growth starts to decelerate, first slowly and then rapidly. The unemployment rate will rise at some point. Over time consumption, and prices, decelerate and then stagnate.

=> contraction and bottom

Economic indicators deteriorate. Financial markets start suffering visibly.

The bottom of the cycle is reached when economic growth arrives to a minimum, exactly before it begins to recover. Credit is harder to come by.

It is a painful moment in the economy, with a low point in consumption and a high point in unemployment.

After the bottom, the cycle starts again.

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How to understand where we are in the cycle

GDP growth is the measure normally used to confirm in which phase of the cycle an economy can be.

But GDP growth is a measure that looks at the past, meaning that waiting for GDP numbers could be too late for investors to know what to do.

A number of key metrics, from PMI leading indicators of growth to unemployment rate, from interest rates to the speed of inflation, can help us to understand where we could be in the cycle.

Be aware, it is more an art than a science: economic cycles have historically lasted between 18 months to several years.

Here at Monetharia we are building a proprietary software with hundreds of systematic indicators that aims at supporting our investment decisions by identifying where are we in the cycle and how to best position our dynamic portfolio to take advantage of any market conditions.

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Factors influencing the cycle

The economic cycle is influenced by both private and business pending, but it is also managed by government spending (also called fiscal policy) and monetary policy by central banks.

With fiscal spending, governments may spend or save, then stimulating the economy in different ways, causing growth to accelerate or slow-down.

With monetary policy and changes in interest rates, central banks may stimulate or constrain private consumption and bank lending, also affecting growth and inflation.

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Economic cycle and markets

To reiterate here what we have anticipated in the intro, the job of stock and bond markets is to guess where we are in the cycle and act accordingly.

Do investors expect higher inflation as consequence of strong growth in the later part of the cycle? Then central banks should hike interest rates and bond yields should move higher (prices lower), so it would be the time to reduce exposure to the asset class, for example.

Or do investors expect a recovery after a recession? Then, it would be time to invest in small cap stocks and emerging markets.

In general terms, financial markets try to anticipate the cycle by 3 to 6 months, and move accordingly.

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Bonus: your emotions as investor along the cycle

One of the most difficult things about investing is managing our own emotions. Emotions trigger actions: as markets fall, for example, it is typical to feel the need to sell before it's too late. This means to sell often at the wrong time.

To become a better investor, we need to be aware of our own emotions, understand that an investment process is better than acting with instinct and gut, and to observe our empotional impulses without acting on them.

Why are we talking about emotions here?

Ups and downs in the economic cycle, and therefore in markets, trigger in us very specific emotions to be aware of:

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=> early cycle: from depression to optimism

We said earlier that a cycle starts after a crash, or a recession. Previous depression is followed by cautious optimism, as the economy shows signs of a rebound with (usually) low interest rates.

Stock markets bounce, usually catching investors by surprise.

But usually many investors are out of the market because of recession pains. As the market rises, investors miss the early rebound.

On the emotional side, investors might feel shaken. Go against your fears: instead of staying out of the market, or selling as soon as markets recover, think about staying invested or - even better - adding to risk assets early.

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=> mid cycle and peak: excitement and overconfidence

Strong growth and strong markets feel exhilarating. Unemployment is typically low, with corporate earnings at the top.

While in mid cycle it is time to keep buying risk in markets as the economy steadily improves, the issue at the top is that ongoing growth (of both the economy and markets) make investors feel invincible.

Overconfidence makes investors buy more risk (in stocks, bonds, cryptos, etc) at high prices. The drive here comes from many people making many, so the average investors does not want to stay out of it and imagines that the good times will continue.

The trick here is to identify (hard!) that we are at the top and start selling some positions in risk assets. It is often the time to accumulate bonds that not many want.

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=> late cycle: uncertainty

After the peak, the economy slows down. Markets will continue to do well for some time, but then they would start sliding at some point without any announcement.

It is normal for investors to hope for the bull market to continue, but prices may fall unexpectedly.

Lookout for a transition in markets and the emergence of uncertainty in your mind. This stage is tricky as there are two things to consider: do not panic in the first part of the late cycle, as things will perform well for some time; in parallel, be ready to reduce risk before a market downturn will hit unexpectedly.

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=> contraction and bottom: fear

A market bottom is painful and depressing. All markets drop, but safe government bonds (which is why it is important to have diversified portfolios).

Even with a solid investment plan, investors may feel failure and have regrets about not selling earlier.

Great if you have followed the advice from the step above to sell at the right time (hard!). If not...

...the strongest feeling will be to keep the money you have left, selling at the bottom and locking-in losses. That would be wrong.

Deep market drops are the time to slowly invest back. Resist the urge to sell, or find the courage to rebuild your positions.

In summary, understanding economic cycles is absolutely key to know how to balance the right investment mix and ride your emotions.

We reinforce the message that here at monetharia.io we are systematically categorizing leading and lagging indicators in our investment software to anticipate where we are in the cycle, how we could best allocate assets for any moment in the cycle with both (1) a dynamic approach (daily and weekly) that can maximize returns for the desired level oif risk, and (2) the required discipline to avoid acting with the urge pushed by our own emotions.

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