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MARKET CYCLES: THERE IS A SEASON

Comparing investment markets to the seasons may seem a bit farfetched. But it can actually be an instructive way to introduce the concept of market cycles — the recurring expansions that push prices up followed by the inevitable contractions that drive prices down — only to be followed by yet another expansion and another contraction.

A major difference of course is that a market cycle, unlike a season, doesn't fit neatly into an annual calendar. But then there's no guarantee that snow will fall in December or flowers will bloom in March (pace, readers in the southern hemisphere). So it's worth reminding yourself, whenever the stock market enjoys weeks of steady gains or suffers months of flat or falling prices, that you're seeing just a small segment of a much longer loop.

THE TEMPERAMENT OF INVESTORS

What makes a market cycle truly different from the seasons, however, is that investors have a major impact on the former and absolutely no effect on the latter.

That's largely because a stock market surges when investors buy and falls when investors sell. A number of factors, primarily economic and political, influence these decisions. For example, when corporate earnings are strong and employment is robust, investors want to profit from this prosperity by owning stock. But if earnings fail to meet expectations or investor confidence is shaken, investors desert stock for safer alternatives, and the stock market slumps. Then, as the economy is re-energized, perhaps encouraged by a Federal Reserve cut in interest rates, the pace of stock investing picks up again.

This movement from high point to low point and back to a high is known as a full market cycle.

DIFFERENT MARKETS, DIFFERENT CYCLES

There are similar cycles in other investment markets — including those for bonds, commodities, and real estate. But while the up-an-down patterns are the same, the timing and the duration of the cycles vary. A full stock market cycle, for example, may take less than a year, but in the case of real estate, it can stretch for a decade or more.

In some cases, the markets in different asset classes are correlated, which means they are influenced by the same factors. For example, stock and bond prices are both affected by interest rate changes. In contrast, interest rates have little or no effect on the price of corn or wheat, though weather and market demand have a major impact. For this reason, agricultural commodities and bonds are described as noncorrelated.

RIDING A MARKET CYCLE

You can deal with market cycles defensively, by resisting the impulse to sell off your holdings when your portfolio is losing value. While it's a good idea to shed individual investments that aren't meeting your expectations, it's almost never smart to sell extensively when an entire asset class is slumping. For one thing, you may take a loss. And you won't be in a position to benefit when the market bounces back, since you'll no longer own the investments that may increase in value.

Another, and perhaps more effective, way to deal with market cycles is to be proactive. That means when investment prices are falling across the board, it's often time to buy. Not only will you pay less, but when the market rebounds — as it invariably has — you're positioned to share in the gains.

Better yet, you can adopt an asset allocation strategy to ensure your portfolio always contains a variety of asset classes, including some that correlate and others that do not. For example, if you always own stocks and bonds in the proportion that you've determined suits your goals, your time frame, and your risk tolerance, then you're positioned to benefit from whichever of the two asset classes is providing the better return at any given time. If they're both strong, that's a plus. And if they're both in the doldrums, ideally you'll be invested in an asset class that's not correlated, and is marching to a different market drummer.

Since it's virtually impossible to time your investments so that you always buy on dips and sell on peaks, asset allocation is really the only way to protect yourself from this type of market risk and potentially benefit from its rewards.

Market cycles are a fact of investing. While you can't predict when a cycle is peaking or is about to bottom out, recognizing that investment values continually move up and down means that you can anticipate this movement. Over time adopting a strategy to capitalize on it, rather than buying and selling impulsively in response to immediate market fluctuations, can potentially yield far better results.

Disclaimer: This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.