Investing Through Market Cycles

Investing through market cycles is a daunting task but necessary for any investor. The market cycle is more relevant now, because no one alive today has experienced a world without the US Federal Reserve and some form of interest rate (Figure 1) manipulation/quantitative easing. Furthermore, the working population in 2023 experienced a downtrend of the risk-free rate (Figure 2) throughout their entire adult life. In other words, buying the dip has worked out wonderfully for the past four decades. To compound the situation, the last two decades were mostly under 2% interest or near zero interest which results in high valuation, easy access to credit, willingness for consumers and entities to load up with cheap debt, and a general blind euphoria to the mantra that assets only go up.

The 20th century experienced the highest growth in world population (Figure 3), economic production (due to oil, general peace, the American economic machine), and prosperity in history (Figure 4). We were on an incredible bull run with falling interest rates, incredible boosts in population, advances in technology, and advances in globalization since the 1980’s. We had massive gains in GDP and even faster growing debt levels (Figure 5). In this article, we walk through why market cycles exist and how to recognize where we are in relation to a current cycle.

Figure 1: US Fed Fund rate according to macrotrends.com (interest rates on y axis, years on x axis)

Figure 2: US 10-year Treasury yield according to macrotrends.com (interest rates on y axis, years on x axis)

Figure 3 – Source: https://data.worldbank.org/indicator/SP.POP.TOTL?locations=US

Figure 4: GDP per capita representing overall production per person, source: https://data.worldbank.org/indicator/NY.GDP.PCAP.CD?locations=US

Figure 5 – Source: https://data.worldbank.org/indicator/GC.DOD.TOTL.GD.ZS?locations=US

Why Do Market Cycles Exist?

In a word, credit. Credit creation is our greatest friend but worst enemy. Throughout history, credit allowed consumers and businesses the ability to purchase assets without 100% cash on hand. Credit allows consumers to purchase cars, houses, educations, and now consumer goods (via buy now pay later shadow credit systems). Credit allows businesses to invest in projects and build infrastructure today and boost production and prosperity. At some point, this credit needs to be repaid and thus the market cycle exists. When consumers, entities, and societies buy more goods and services than cash on hand, they eventually need to spend less than cash on hand to repay the debt.

Societies learned through time how to combat these cycles, and the Federal Reserve system was a biproduct of this train of thought. The United States went through several iterations of a central bank with the most recent established in 1913. Since that date, the United States has combatted the market cycle with interest rates and quantitative easing (QE). The result of Federal Reserve actions was generally great economic and prosperity gains accompanied with great credit creation. The past two crisis specifically, were combatted swiftly with Federal Reserve asset purchases.

Source: https://fred.stlouisfed.org/series/WALCL

Recognizing the Market Cycle

Market timing is universally accepted as impossible and we support that view. However, there are clear indicators for investors to understand where the market is in the current cycle in order to allocate investments accordingly. Below are the most relevant indicators for investing through market cycles.

1. Interest rates: In the United States, this is the Fed Funds Rate and Treasury rates. These rates are different and it’s important to know why.

   • The Fed Funds Rate is the interest rate at which banks lend and borrow money from each other overnight to meet reserve requirements set by the Federal Reserve. This is a rate that the Federal Reserve has full control over. This is monetary policy 1, and is used to control the amount of cash in the system.

   • Treasury rates are the rate of return on government issued bonds. The Fed does not have direct control over these instruments as the price is set by supply and demand. The Fed does manipulate these rates through monetary policy 2, Quantitative Easing (QE). During economic crisis, the Fed purchases treasury securities on the open market to stabilize the system. Ideally, once the crisis is averted, the Fed should sell these securities as Quantitative Tightening (QT).

   • Pay attention to interest rates.  They determine asset pricing.

2. Valuations: Historically, valuations for companies average 15 price over earnings and 3 or 4 price over sales. Companies were valued at 25 times sales during the tech bubble, and 30-50x sales during the Covid bubble. Valuations are to stocks what implied volatility is to options. The valuation of a stock is a derivative of the underlying business’ cash flow. Valuations are based on market sentiment to that underlying business. Valuations can be extremely high or extremely low for the same cash flow, the difference is market sentiment.

   • In 2000 and 2008, most of the loss in stock price was due to valuation contraction.

3. General Government Sentiment: The government sentiment in markets is the most important aspect to market sentiment and business development. The government will usually be clear on their stance for business. The main example taxation.

4. The Credit Cycle:

   • Early in the cycle, properties/business ownership are king.  These valuation appreciations will return far more than cash throughout the cycle. 

   • Late in the cycle, cash is king.  Late in a debt cycle when valuations are frothy, credit is maxed out, and production is peaking, there may be a large increase in asset prices (change in the slope of returns on a logarithmic scale).  But this is mute compared to the valuation contraction that will come.  Cash is king at this point.  Even though inflation may be happening in the real economy during a peak cycle, cash will appreciate compared to asset prices. 

   • Access to credit vanishes during a market contraction, and is seemingly infinite during the cycle top.

5. Market Sentiment: This is a personal favorite because I’ve seen it. I worked with a trucking company as a Controller, and during the Covid bubble, all the truck drivers were telling me about the stocks they bought during the week. Everyone wins and thus is a “great stock picker” during bubbles. I haven’t heard a word about stocks out in public in the last 12 months.

   • A more data driven way to check market sentiment is Investors Intelligence which presents a survey of US advisor sentiment.

Investing through Market Cycles

Since the 1980’s, interest rates have been in decline, income levels were rising, debt has been rising relative to income levels, and valuations along with production have increased.  Now in 2023, with rates near zero, and inflation on the rise, the fed is increasing the fed funds rate, and stopping the asset purchases (quantitative tightening) which is driving Treasury yields up. This series of events is crushing valuations that were elevated during low interest rates and easy credit creation from the past decade.

During times of bubbles/extreme wealth creation, it’s better to sell financial assets and hold more cash. Diversify holdings between cash, real estate, financial assets, and your own income producing ability. Accumulate cash during times of wealth creation.  During times of wealth destruction and declining asset prices, buy financial assets.  Financial assets operate on valuations more than fundamentals. (like an option priced with implied volatility). During good times, low interest rates, and loose credit valuations are high.  During bad times and contracted credit valuations are low.