”Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
Last night, I had not one, but two invitations for dinner. According to the motto ‘First-come, first-served’ I skipped football and delicious home cooking by a friend’s wife. Instead I spent the evening at a lebanese restaurant to celebrate a just finished stage in a project I help to manage.
Why should this be of interest on a website dedicated to business & investing, you might ask. Well, to my surprise, the talking-points over the almost authentic lebanese mezze moved from office gossip, pros and cons of the smoking ban and various Easter/1 May holiday plans also to ‘my’ subjects.
A few guys – but no lady – were interested to know more about financial markets. ‘‘I heard that gold is a safe investment or is now a good time to buy stocks?‘ To be honest, I wasn’t expecting such kind of questions on a night out with the office.
Unfortunately, I had no ‘hot stock’ at hand that everyone should instantly buy to make a fortune, so I tried to explain what kind of investments should be considered in the different stages of an economy.
Again, to my surprise, a few people kept on listening and found my explanations and drawings on a paper-napkin of the restaurant somewhat interesting they asked for a follow-up next time we meet.
That’s why I thought to share yesterday’s explanations on this website:
Graph 1 shows the different stages of an economy in the cycle resp the asset-classes like bonds, stocks or commodities that should be considered to buy or sell in each stage.
Let’s explore the different stages:
Stage 1: The economy is still contracting, but stocks are approaching their lows and commodities aren’t far behind. Once bonds demonstrate they have bottomed, it’s a good time to start buying them since they lead the other two asset classes in a recovery.
Stage 2: At this point, the economy has bottomed. Stocks have begun to move up behind bonds.
Stage 3: As the economy improves, inflation begins to creep in, which is good for commodities that have bottomed and stocks at least in the early inflationary stages. This is a good time to buy commodities. Bonds, stocks, and commodities move up together during stage 3 as the economy continues to expand.
Stage 4: At this point, economic expansion is slowing and interest rate hikes should have been instituted in an attempt to slow inflation (although that didn’t happen in the last recovery). As interest rates rise, bond prices soften since interest rates and bond prices move inversely to one another. It’s time to sell bonds. Stocks and commodities are still moving up, but stocks will begin to slow as interest rates begin to have an impact on corporate earnings and borrowing rates.
Stage 5: Economic expansion has peaked as interest rates take their toll on corporate profits and the economy. It’s time to sell stocks. Commodities are still rising, but they will begin to level off soon. As we learned in 2007/08, the bigger the bubble that has formed in various assets during the expansion phase, the more severe the correction.
Stage 6: Efforts to cool inflation have worked, but now the economy is contracting and this trend gathers momentum. It’s time to sell commodities. Stock prices are still falling, even though corporate profits have begun to improve.
Currently, Romania’s economy is probably positioned towards the end of stage 3 which indeed would speak for an investment in commodities like gold. But graph 1 shows as well that the best time to buy stocks has just passed.
It’s no coincidence that the general public and inexperienced investors ‘discover’ the stock market usually when the general economy is expanding, job-security is high and salaries are rising. That’s good for consumers, but not the best time to enter the stock market. Be aware, that you are late in the game and if you miss to sell again in stage 5 at the latest – and that’s exactly when the economy is ‘booming’ and everybody is optimistic – you risk to lose money with stocks.
But most new investors do exactly the opposite, they buy even more high valued stocks while the market tops and wait too long to sell until it’s too late into a falling market, thereby often lose money with their investments. After this unpleasant experience they usually decide to keep away for a while from stocks in the future – only to miss the perfect entry in the next cycle..
This happens not only in Romania but around the world in every economic- and market-cycle. Blame it on greed, but many wrong investment-decisions are actually made because of perfectly normal human behavior and the tricky investor psychology, as graph 2 with US-data for the decade 2004-2014 shows.
Graph 1 – The 6 stages: When you should buy or sell to have a better chance to earn some money within the economic cycle.
Graph 2 – Investor Psychology: What most inexperienced investors really do and why they lose money