Why Understanding Market Cycles Matter

July 27, 2015

In 2009, my parents began an eight-year stint of paying college tuition for their two children.  Nearly one year earlier the stock market crashed taking with it half of my dad’s retirement savings and half of the money he had saved up for our educations.  Fortunately, instead of panicking and selling out in 2008 my dad not only held on but continued his contributions, and as the market continued its cycle his investments came back and then some. 

 

Famed investment manager Ray Dalio, whose company was one of the few with positive performance during 2008, describes market cycles using what he calls the three big forces.  The first force is what he refers to as trend line productivity growth.  This can be thought of as the historical trend that the market has followed since its inception – a slow upward path.  The second force is the long-term debt cycle.  This trend reflects major bubbles and market crashes that occurs once every 50 years or so.  Both the great depression of 1929 and the recession of 2008 fall into this category.  The final force reflects short-term cycles.  These can be thought of as basic market corrections that occur every 5-10 years or so.  The three forces are graphed as follows:

 

retrieved from: 

http://bwater.com/Uploads/FileManager/research/how-the-economic-machine-works/ray_dalio__how_the_economic_machine_works__leveragings_and_deleveragings.pdf

 

Market cycles matter because they inform how we should invest based on our time horizons.  If we have a long-term time horizon such as investing for retirement or a child’s college expenses then, looking at the first graph, we should expect the market to naturally slowly work its way upward over time.  In the mid-term and short-term, however, we should also expect the volatility of the 2nd and 3rd graph – little dips every few years, with a big drop likely at some point in our lifetimes.  Collectively, the three forces look a little something like this:

 retrieved from: http://www.economicprinciples.org/

 

During the chaos of 2008 when everyone was feeling the pain of the second force, my dad was remembering the first graph.  Over the past 6 years, we have been on the upward slope of the curve, and my dad has safely been able to cover the costs of two college educations that he would have been unable to if he had sold out when the market fell.  While it is impossible to predict the timing, it is inevitable that these cycles will repeat themselves, and we will find a downward slope again.  When that happens, it is important to consider the lessons of the past. Often, the only long-term losers in a market downturn are those that panic and make an emotional decision to sell. If history is any guide, we will once again find the long-term productivity curve and find long-term growth in the market.

 

 

Dalio, Ray. (2015). Economic Principles. Bridgewater. http://bwater.com/Uploads/FileManager/research/how-the-economic-machine-works/ray_dalio__how_the_economic_machine_works__leveragings_and_deleveragings.pdf

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