An economic business cycle comprises a period of time, usually 5 to 8 years, beginning with a recessionary trough – i.e., the bottom of the cycle – and ending at a peak period of growth or economic activity. Financial markets usually follow the same pattern, although sometimes with leads and lags. Over the cycle, from lowest to peak valuations, stock prices can offer exceptional performance for investors. On the way down, however, from the peak to the next trough, as recession takes hold, stocks can decline dramatically and have often lost 50% of their value.
Why do we have cycles?
Why do we have cycles? In a nutshell, the crowding or herding instinct by investors promotes the cycle. Investors are always the most optimistic at the top. At the margin, the market then runs out of buyers and worried investors can then become a big pool of sellers. The smaller number of buyers are overwhelmed by the sellers, and a market correction sets in. The downturn feeds on itself until some reasonable economic value returns, bringing more balance to the marketplace.
Former Federal Reserve Chairman Paul Volcker has written an excellent book on the topic, Rediscovery of the Business Cycle. His conclusion is that, try as it may, government is not able to manage the economy in an effort to eliminate the cycle. John Maynard Keynes believed an activist government could be counted on to provide stability. In practice, tinkering with the economy in order to compel it to operate as government desires has had a problematic history.
Debt and lending also have a tremendous influence on cycles. There are inflationary and deflationary cycles throughout history. Each is usually the result of uncontrolled or excessive accumulation of debt.
Many market observers state that the housing market determines the business cycle. This suggests that the rise and fall of what may be the largest investment for the majority of individuals directly influences the economy and causes the cyclical ups and downs. While this seems plausible, and has been documented, what is really at work is investment dollars concentrating on a particular asset – which in this case happens to be housing. It could be any other, such as stocks or gold or bonds. Cycles are therefore often the result of capital concentration.
Investors tend to chase a trend as prices are going up, to the point where the underlying asset becomes uneconomic. It is also a simple issue of mathematics. If every year during a boom there is a constant or growing sum of investment dollars flowing into a particular sector, it pushes up the price. If the price starts at $100 and then rises to $500 it is not because $400 was invested during the boom period. A much smaller amount was invested. At the peak, the total capital value becomes unjustifiable, and is a much greater sum compared to the small fraction of money intent on bidding it up. The situation becomes unsustainable.
This same process is at work in any auction market. The stock market is an auction market just as the housing market is an auction market. The price is set by the last bid and offer and so a small amount of money is responsible for moving up the price of the entire asset.