Economic Cycle vs Market Cycle

The S&P 500 index contains 500 large companies listed at the New York Stock Exchange and the Nasdaq.

The index can be viewed as a fairly good base, when it comes to examine the performance of different sectors like technology-, pharma-, energy- or cyclical stocks.

I checked the data for the past 10 years and came up with the result, that – on average – the performance-gap between the best and the worst sector is 35% yearly. You can lose or gain a lot of money by choosing the wrong or right sector.

Not the only, but an important factor for the 35% difference on average is the economic cycle. There are top and flop stock-sectors in each economic cycle.

In general, an economic cycle develops in 4 stages:

  1. Full recession
  2. Early recovery
  3. Full recovery
  4. Early recession

For an easier approach, you could think of these 4 stages as winter/spring/summer/fall.

Now, there is another cycle of particular interest for investors:

The market cycle – he has 4 stages as well:

  1. Bull market
  2. Market top
  3. Bear market
  4. Market bottom

As mentioned in the previous chapter, the market is trading the future – and the future only. Therefore, as a rule of thumb, the market cycle is one step ahead of the economic cycle.

So when the economy is in full recession and people are loosing jobs or confidence because the news on television and in magazines are grim, the market is already in the next phase.

In other words: the real economy is still in cold winter, the stock market already enjoys the spring.

This market phase is called bull market. The sector – investors are now buying in – is called cyclical stocks, in anticipation that this sector profits the most, when the recovery finally arrives in the real economy in a few months.

A typical cyclical stock is Caterpillar, because construction rises in an early recovery and heavy machinery is needed. Others are aluminium producer Alcoa, car manufacturers like Ford or, since also the general trade recovers, a delivery company like FedEx.

Important take-away: when you wait to buy cyclical stocks until the real economy recovers, you are with a high degree of certainty too late in the game, pay a too high price for this shares and  – allow me to speak blunt – your performance sucks.

The pattern of different cycles goes on when the real economy eventually comes out of the recession and recovers – in other words, is transforming from winter into spring and people enjoy the first warm days, the market is already in his hottest phase.

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In stage 2 of the cycles, smart money meets dumb money. That’s profitable for the smarties and dangerous for the dummies. More in the next chapter: http://www.theleader.ro/smart-money-vs-dumb-money/

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