Investing in Equity - Asset class cycles

It’s almost every other week now that the market seems to be hitting new highs and you can find people everywhere heralding the equity markets. Spoiler alert for what is to come, it is not going to last forever.

This article and the ones to follow will be an expansion on our retirement planning and “Understanding Asset Cycles” article. All investors try to follow a simple rule that is “Buy low, sell high” but this is often easier said than done, especially if you are at a not-so-favorable position in the cycle.

Here is a quick way to picture what an asset class cycle could look like for two assets:

Equity and Real estate. This graph is not representative of the returns of these assets but just to show you how they can have different durations. In this example, equity goes through two full cycles as real estate completes one.

Let’s briefly outline the various stages in the business cycle:

Early-cycle phase: There is a sharp increase in economic activity moving us out of a recession into positive growth. This is accelerating and we see easing monetary policy and the markets shoot up.

Mid-Cycle Phase: This is usually the longest phase in the cycle and has moderate but strong economic growth. Economic activity gathers slower momentum, credit growth becomes strong and profitability goes up.

Late-Cycle Phase: This cycle is usually peak activity and a subsequent overheating of the economy. Capacity is constrained leading to an increase in inflationary trends.

Recession Phase: We see a contraction in economic activity. Corporate profits decline and credit is scarce for all economic actors.

Other than the business cycle, there is also a secular cycle anywhere between 10 to 30 years that is uncorrelated to the business cycle. There are also disturbances in the very short term, between 1 to 12 months. These are the three cycles that govern the equity markets.

Here are a few things to understand when investing in equity:

• Darts and Targets: Imagine if you were standing in a dark room and your friend told you that if you threw a dart, in whatever direction, it would definitely hit a target. You don’t know how or when, but it will. This is much like how economists predict recessions, we don’t know how or when, but a recession will come.

This holds true for other phases too, we don’t know when the next phase will come along but by looking at the prevailing market conditions one can assess with some certainty what phase you are currently in. Returns in the equity markets are indicators of them.

The returns are superb in the Early-Cycle phase. The economy’s getting ripe and ready for all the activity to come. There are good returns to be made at the Mid-Cycle phase too. They slowly start to diminish in the Late-cycle phase as the peak of the cycle has passed and at the recessionary period, the favor may all together shift to treasury bonds!

It is important to remember through these phases that Equity is a volatile, long-term investment. Don’t be spooked by short intervals of volatility, instead understand the business cycle so you don’t end up at the wrong end of that cycle

• Don’t let your emotions take over: Watching your money grow is a wonderful feeling. It feels even better when you watch it grow exponentially. A “Bull-Market” is a period when prices rise consistently for a period of time. It is crucial to be rational and objective about these times because Bull Markets don’t last long and get rich quick schemes in the stock market usually leave you in the opposite position.

Remember to always do your due diligence before investing in any stock or equity instrument.

• Buy and Hold?” Forget about it!: A common strategy of investing in equity is the “Buy and Hold”, buying stocks for the long term and holding them patiently to grow. For example, if you had bought the top 5 stocks by market cap in 1995 and then forgotten about them till 2020, chances are you would’ve made a good return but definitely not as much as if you could have if you were constantly reevaluating your portfolio.

Going fully passive may come back to bite you in the future because If you don’t actively monitor and reallocate your resources efficiently, you risk earning a return lower than debt instruments (which are safer so why even take the risk with equity) or even inflation eating away at your returns.

The stock market is notoriously volatile which is what makes it such a great place to invest your money in (when it’s good, it’s great!). With equity, you are in for the long run, understanding these cycles and their phases can help you greatly with getting consistent returns and growing your wealth, and also giving you some much-required peace of mind during turbulent times.

Our Other Articles on:

1. How to Start Retirement Planning - Understanding Asset Cycle - Link

2. Active vs Passive Investment - Link

3. Should You Invest in Cryptocurrency - Link