Market Cycles

Let’s start off this post with a question: What do forests and the stock market have in common?

They both tend to follow cycles.

Forests tend to follow a cycle: They start from a few seeds and some fertile soil. Over time, those seeds grow into a lush, green forest. The forest becomes too overgrown and begins to fill with dead wood that dries out. Eventually, something like a lightning strike, a campfire, or a carelessly discarded cigarette sparks a fire, and that fire ravages the forest. When the smoke clears, all that is left is a gray, ash-covered landscape. Time passes, and animals begin to return to the land. Some of those animals carry seeds, which fall into the soil, and with the help of the fertile, ash-filled soil, begin to grow into trees again.

So what does this have to do with the stock market?

The same thing (metaphorically) happens with the stock market.

The cycle starts when nobody wants to own stocks. Everyone are afraid that they’ll lose their entire investment, so they steer clear. A few investors start doing some research, and find a few stocks that they believe are cheaply priced and will grow tremendously over time, so they start buying. With time, others start to catch on, and more people buy in. As more and more people buy these stocks, the more the stocks increases in value, and the more money the stock owners make. These people then start to become renowned for their investment prowess, and word gets out how smart and rich they are. As word spreads, people copy their moves in hopes of achieving a similar result. Eventually, the price of the stocks get so high that people become fearful that everything is extremely overpriced (also known as a bubble). When this happens, less people buy stocks, and some even start selling. All of a sudden, something spooks the investors, such as bad news about the economy or rising interest rates, and the trickle of selling becomes a gusher. Stock prices fall like a rock, and money is lost as fast as it was made. Eventually, everyone has sold their stock, and horror stories of people losing everything run rampant. Nobody wants to own stock. But then, along comes a group of investors.

These market cycles have been present since financial markets began. Extreme examples of these include the Dutch Tulip Mania of 1634-37, during which, prices for individual tulip bulbs reached up to 10x the annual income of the average Dutch worker, and more recently, the 2008 Great Financial Crisis (GFC).

Let’s use the GFC as an example. In the early 2000s, the stock market was recovering after being decimated by the end of a bubble in new internet companies. With time, people began buying stocks again, and the market began to rise. As the early 2000s became the mid 2000s, some people began to worry about the stock market being overpriced. However, prices continued to rise. Eventually, rising interest rates led to a rapid decline in the red-hot housing market, which then spread to the stock market. America’s financial industry faced massive losses and the threat of bankruptcy. Millions of people lost huge amounts of their money, and in many cases, their homes. There was a fear that gripped people ranging from the average joe to Wall Street titans that the global financial system would collapse. People couldn’t get rid of investments fast enough. But then, eventually the selling slowed, and investors began buying again. The buying continued, and the stock market went on to post one of its best decades of all time in the 10 years after the GFC.

Not all cycles are created equal. Sometimes, the economy is managed by the Federal Reserve, which acts like a forest crew doing controlled burns to reduce the available fuel for forest fires, and the swing between selling and buying is fairly gentle. Other times, the market is allowed to run uncontrolled, and the pendulum swings much farther in each direction.

While it is impossible to predict the exact timing of these cycles, it is possible to get a rough sense of where you are at in the cycle by paying attention to things like people’s attitudes about the market. We will get into this in more detail in another post, but for now, I want to convey that these cycles exist, and will likely continue to exist for as long as we have financial markets.