Predicting The Economy
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Understanding the market cycles and business cycles
Hi, In this video, we see how the market cycles and business cycles play out and how this understanding can be advantageous for traders and investors.
Both markets and businesses are driven by human behaviours. Emotional humans tend to overreact in good times as well as in bad times, which results in the cyclical behaviou
r of markets and businesses. While the emotions of humans are busy creating cycles, there are less emotional smart humans at the other end of the spectrum, who are relatively unperturbed by these extremes and wait for such overreactions to play out.
Because markets are driven by underlying business performance, it’s only natural for naïve traders to place their trades based on the current economic performance. This leads to new traders becoming bulls when the economic data is at its strongest, whilst becoming bears when the data is all red.
There are two problems with that approach to the markets.
The economic data is a lagging indicator of what the economy is really doing. The data always shows the past performance and therefore isn’t actionable in real-time, also;
Markets always follow a forward-looking mechanism. They don’t go down when the economic data is looking bad. Instead, they go down when the market participants foresee the economy to be in bad shape in the near future. The markets always see the best and worst before the economy sees it.
Therefore, you must be aware of the leading nature of the market to trade well and trade profitably.
Let’s understand how the link between businesses and markets has played out in the past cycles.
Here is a chart showing the performance of the economy and S&P500 over a 75-year period from 1947 to 2023
The shaded areas in the chart show 11 recessions and slowdowns in the past 75 years, wherein the GDP declined for two consecutive quarters. Some of these recessions were prolonged lasting more than 4 quarters, while the shorter ones lasted for 2 to 3 quarters.
Let’s zoom in to these time periods to observe how the market reacted to these recessions.
Here is a chart showing the recessions between 1947 and 1963. In most cases, the S&P 500 peaked and started declining before the recession settled in. The GDP data comes with at least a month's lag, by the time the GDP data came out, the index had already reacted to the data. Unless the data throws in a significant surprise, the index generally does not react to the GDP news, when it finally comes out.
Another key point to note here is how the market index behaves during a recession and afterward. Most times the market bottoms before the economy bottoms. It was very clear in 1949 and 1953, and not so clear in 1957 and 1961 cycles when the market bottom coincided with an economy bottom. However, another point to note here is that the economic data is not real-time data while the market data is real-time. Therefore, by the time the economic data gets out and the economic bottom is clear, the market has already marked a bottom and moved on.
Let’s look at another period from 1967 to 1992.
Here also, the market bottomed before the economy and took to the new highs much before the economy. As the governments and central banks became more responsive to these cycles, the market has become more efficient over time, cementing the leading nature of the market.
Let’s now look at the most recent period from 1998 to 2023.
There are only two recessions in this period. If we remove the pandemic-induced recession, the current period would be the lengthiest period of economic expansion in the entire 75-year history.
In the 2008-2009 economic recession, the market again bottomed before the economy, but took its own time to scale back to previous highs due to a period marred by extreme risk aversion, given this was the most intense recession after the 1930s great depression. The market, nevertheless, shed the risk-off approach in the early 2010s and a new bull market began thereafter.
You may now wonder, what leads to the market bottoming before the economy and scaling new highs before the economy hits new highs.
The key explanation for this is that the market is full of scary beings who tend to react and sometimes overreact to anticipated bad data. This leads to market bottoms being formed in advance.
When this fearful bunch of traders are selling, the baton is taken over by value investors, who are a more long-term focused, patient breed of investors. They see value in oversold prices and jump on the opportunity.
Once the bottom is in place, then comes the breed of smart investors. These investors collect insights from several sources including management and industry circles and keep buying the economic recovery before it is visible in the data. This breed of investor plays a major role in any bull market and is responsible for a major part of the move.
Then comes the momentum crowd, they jump in when the momentum starts, and this perpetuates further for quick and often big moves.
Another key point to note is that it isn’t that the markets fall only during recessions. There are plenty of cases when the markets have seen deep corrections for several other reasons, including the fear of rate tightening, wars, and economic and political instability in other nations. During these times, the markets see swift corrections and recoveries, which again is a result of an overreaction by the emotions of crowds, followed by the support of the value investors, and continuity through smart money and momentum plays.
When you are trading financial markets, it’s essential to know what we have illustrated in this video, because without this insight, you could be risking equity at the wrong time. Once you understand the leading nature of markets and how they react to economic and business activity, you can trade much more smartly and profitably.
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