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Why do we have cycles?

The Business Cycle

An economic business cycle comprises a period of time, usually 5 to 8 years, beginning with a recessionary low (the trough of the cycle) and ending at a peak period of growth in economic activity. Financial markets usually follow the same pattern, although sometimes with leads and lags. Over the full cycle, from low to the peak in valuations, stock prices can offer exceptional performance for investors. On the way down, however, from the peak to the next trough, stocks can decline dramatically, often losing 50% of their value as a recession takes hold.

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, bidding up prices at the margin. The market then runs out of eager buyers in relation to investors who need or want to sell. At the top, the smaller number of buyers are overwhelmed by the sellers, and a market correction sets in. The downturn can feed on itself for many reasons until some reasonable economic value returns, bringing more balance to the marketplace.

Former U.S. 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, a reknowned British economist, 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 challenging history.

Debt and lending also have a tremendous influence on cycles. Leverage will accentuate the cycle. There are inflationary and deflationary cycles throughout history. Each is usually the result of uncontrolled or excessive accumulation of debt.

Many pundits state that the housing market is a key, influencing factor of the business cycle. This suggests that the rise and fall of what is arguably the largest investment for the majority of individuals directly impacts economic activity and causes the cyclical ups and downs. While this is certainly plausible, and has indeed occurred, what is really at work is investment capital concentrating on a particular asset which, in this case, happens to be housing. It could be any other asset such as stocks or gold or bonds. 

Business cycles are often the result of capital concentration leading to overvalued and uneconomic asset prices.

Investors tend to chase a trend as prices are going up. It is a simple issue of mathematics. If every year during the good times there is a constant or growing sum of investment dollars flowing into a particular stock, the price will rise. If the stock price at the beginning of the cycle is at $100 and then rises to say $300, it now takes more investment capital to push it up. At the peak, the total capital value is much larger and can create an imbalance.

This same process is at work in any auction market whether it be the stock market or the housing market. The price is set by the last bid and offer. Conceptually, a small amount of money is responsible for moving up the price of the underlying asset for everyone.

With access to both public and alternative market investment opportunities, we offer a range of investment options tailored to the investor?s risk tolerance. With over 30 years of investment industry experience, George Kurcin leads the Investment team as Chief Portfolio Manager. 

This article is provided for information purposes only. Although the content is believed to be reliable when posted, Stonebrooke Asset Management cannot guarantee this information is current, accurate or complete and does not assume any liability. The information is not intended to provide any insurance, financial, legal, accounting or taxation advice and should not under any circumstances be relied upon without consultation about your specific situation. The information is subject to modification and updating from time to time without notice. 

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