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How investors can identify stock market cycles

November 18, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Stock market cycles

Stock market cycles are something of an enigma - if investors generally know they exist, why don't they get out at the peaks, and buy back in when the market is down? The better you understand the dynamics of market cycles, the better you can take advantage of them rather than being victimized by them.

What makes up a stock market cycle?

Historically, U.S. stocks have averaged a return of about 10 percent a year, but they have not gotten there in a straight line, producing 10 percent year-in and year-out. Instead, there have been extreme market highs and lows cycling around that theoretical straight line. Often, the stock market will average better than 10 percent on its way to a peak, but then make up for that by experiencing a period of negative returns.

Of course, the market can go up and down a little from one day to the next. However, each of those fluctuations is not considered a market cycle.

How to define a bear market for stocks

It is better to look at a cycle as comprising both a meaningful rise and a meaningful fall - otherwise known as a bull and a bear market. Some people use a 10-percent loss to define a bear market, others 20 percent.

A useful way to consider whether the market has really gone through a cycle is if it suffers a fall from which it takes at least a year to recover. Knowing when to invest, such as through an online broker, is critical and being more knowledgeable of stock market cycles can help.

7 ways to identify a stock market cycle

Of course, if everyone knew a bear market was coming, they would get out of the market in advance and that bear market would occur earlier, or at least the bull market would lose some of its steam. Instead though, people tend to pile into markets just as they are nearing their peaks, and panic out of them only after prices have fallen.

Why do people find market cycles so hard to recognize? There are several factors that help disguise them:

1. Length varies

There is no standard length to a market cycle - they can be just a couple of years in duration, or can last over a decade.

2. Valuations differ

Valuations such as price-to-earnings (P/E) or price-to-sales (P/S) ratios help measure how cheap or expensive stocks are, but these valuations reach different extremes from one cycle to the next. For example, there is no set pattern that establishes a P/E of 30 as indicative of a peak, or a P/E of 10 as marking the market bottom.

3. There are cycles within cycles

Besides the stock market in aggregate going through peaks and valleys, there are smaller cycles affecting different types of stocks - value stocks may cycle in an out of favor relative to growth stocks, or smaller stocks relative to big ones. Individual industry sectors may also experience their own cycles.

4. Interest rate conditions are an x-factor

A key variable that helps make every cycle different is the interest rate environment. Low bank rates are good for stocks, so low or falling rates tend to support a bull market. On the other hand, high or rising rates tend to make stocks more vulnerable to a setback.

5. The relationship with the economic cycle is complicated

The market cycle should not be confused with the economic cycle. The market represents what investors are willing to pay for companies, while the economic cycle represents the underlying growth rate of the economy. Although market and economic cycles have an influence on each other, they do not always line up neatly.

6. The sidelines are lonely during a bull market

Getting out at a market peak is easier said than done psychologically. When it seems everyone is making big money in the market, people find it very hard to sell out and wait for the next bear market.

7. The bottom is a scary place

When the market crashes, the prevailing emotion swings from greed to fear. Stocks may be cheap, but people perceive that further disaster is just around the corner. Thus, few people are able to take advantage of market lows.

All of this should tell you that it is folly to try to time a market cycle perfectly. However, having an independent investment discipline that is not driven by the popular attitude towards the market can help you buy more when stocks are cheap, and sell more when stocks are expensive.

Remember, even though market cycles can be functions of fundamental economic conditions, their greatest extremes tend to be driven by psychology - either excessive fear or excessive greed. If you can avoid participating in those emotional extremes, you should be able to smooth out some of the rougher edges of market cycles.

More from MoneyRates.com:

3 investment risk challenges in the modern age

How to approach investments in a sideways stock market

3 reasons why penny stocks are risky: What to know before investing

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