Market Cycle vs. Economic Cycle

Contributors

“We may never know where we’re going, but we’d better have a good idea where we are… and act accordingly.”

oward Marks, founder of Oaktree Capital, poignantly explained in his book, “The Most Important Thing,” how an investor should approach portfolio management by understanding his or her environment. Knowing where we stand in a cycle is imperative to anticipating investor behavior and market trends.

As financial advisors, when we talk about expansions and booms, or recessions and contractions, much of that analysis is expressed in regards to investment cycles. Therefore, it is prudent to draw a clear distinction between what kind of cycle we are referencing: Market Cycle or Economic Cycle.

Market Cycle:

Market cycles have more to do with equities and intricacies of what is going on at a business level. This type of cycle is cyclical in nature – meaning, certain sectors will do well when others do not – typically over the short-term. For example, it is believed that we are currently in a “late-cycle” market phase where investors may start rotating into more defensive-oriented sectors or companies whose products are tied to basic needs like consumer staples – paper towels, for instance.

Additionally, there can be many more variables at play in a market cycle than in an economic cycle; such as product changes, competition, finances, inventory, spending, technology, and other business operation related factors. It is these factors that are often difficult to anticipate and whose outcome is even harder to control.

It is also worth noting that recognizing specific indicators within a market cycle can actually help guide investors in identifying different phases of a broader economic cycle.

Economic Cycle:

Economic cycles refer to the overall state of an economy, which is measured by factors including gross domestic product (GDP), inflation trends, interest rates, government policy, trade, and employment. Governments and central banks attempt to control an economic cycle via monetary and fiscal policy to slow down a rapidly expanding economy and/or speed up a sluggish one. This type of cycle is much more secular in nature, occurring over the long term.

For example, consider interest rates. We have been in a low interest-rate environment for over 10 years, since the Great Recession in 2008. This is a secular trend that has been greatly enhanced by decision making at the Federal Reserve in order to stimulate our economy as it came out of one of the worst downturns in our history. This secular trend would need specific national and/or international forces to change its course.

Now that we’ve described some of the differences between a market cycle and an economic cycle, we believe there is another ingredient that should be noted, not as a distinction between the two cycles, but as a point of commonality – that is, human psychology and behavior that results.

Market volatility affects investor decision making in the short-term but can have long-term effects on investment portfolios and patterns of behavior. Having the confidence and knowledge about where we are in market and economic cycles comes from learning such patterns, not solely recognizing economic trends. When we study past cycles, it is historical hindsight that can provide a degree of “we’ve been here before” reassurance and help us read signs for the next phase. As financial advisors, having this kind of perspective can be quite helpful as we support our clients’ pursuit of long-term objectives.

Now, as we come full circle (or cycle with a pun intended), Howard Marks said: “We may never know where we’re going, but we’d better have a good idea where we are…” Yes, understanding market and economic cycles as separate occurrences, as well as highly interconnected, living, breathing phases, we believe it is important to take the pulse of the economy and market, and see where we are at. With that baseline, understand that we may not know exactly where the market or economy is going, but we can act accordingly and make prudent investing decisions based on specific factors at play.