Let's Go Cycling.
Cycles. Waves. Ups and downs. Dips and rises. However you refer to them, they’re everywhere around us, in a bewildering array of forms, some obvious, some not so much. Many human constructs, such as civilizations, culture, and even investing (which is what I will focus on today) also have several cyclical elements to them.
But instead of diving straight into the cyclical elements in investing, let’s get to them by way of a fun and interesting detour. Let’s first zoom out all the way, as much as we can, and then zoom in layer by layer, exploring the cycles present in each layer, before finally homing in on the cycles that appear in the tangled but beautiful world of investing.
So what’s the farthest we can zoom out to? Well, to the scale of the entire universe, of course! So that’s how we’ll start: with the universe as a whole.
All of existence might be cyclical!
Let’s get things started with the biggest bang we can imagine: the Big Bang. Even if you’re not a physics geek, you almost certainly know what that is. According to modern cosmology, there was a very special fraction of a second nearly 14 billion years ago, when an incredibly hot, dense, and relatively tiny universe started to expand. In an unfathomably brief period of time, the universe grew trillions upon trillions of times in size, before finally settling into what appears to be a more ‘sluggish’ pace of expansion we see today (that’s if you believe 73 km per megaparsec is a sluggish pace. Trust me, it’s not.)
All well and good, but how did that hot and tiny universe come into existence in the first place? That’s the quintillion-dollar question, isn’t it? Before the 20th century and the physics that was developed then, there seemed to be only two sensible answers to this question: either it was some supreme being that had willed the universe into existence, or the universe was eternal and had always existed.
However, modern physics presented a third, serious candidate answer: that the universe might be cyclical. For instance, Sir Roger Penrose, a highly regarded physicist who often collaborated with Stephen Hawking, has put forward a model in which the very distant future of the universe is, in a certain way, indistinguishable from the time of the Big Bang! As a result, under this model, the universe would keep passing through an endless cycle of Big Bangs followed by unimaginably long periods of expansion, and so on.
Thus, the universe as a whole might follow an eternal cycle! How crazy is that?!
Strap yourself. Now for the zoom-in!
Alright, we’ve taken a peep at the cosmos as a whole. What about the levels that make it up? Right away, we see cycles of various kinds in there as well.
Galaxies? Often spiral-shaped, with their stars revolving around their centers.
Star systems? They have planets going around their stars, at their own pace and rhythm, gracefully twirling around like spinning ballerinas.
Planets? Some have satellites going around them too.
Ok fine, so gravity makes a lot of things go round and round. But what happens if you zoom in even further? Let’s focus on the Earth now. What cycles do we see there?
Even apart from the obvious day-night, tidal and seasonal cycles, our planet is home to quite a few interesting cyclical phenomena, most of which you must’ve learned about at school. We have several regular geochemical cycles like the water cycle, carbon cycle, and nitrogen cycle, which have allowed life to flourish. On the flip side, we also have less regular cycles of extinction events, such as the one that wiped out the dinosaurs.
In the midst of humanity (finally!)
Let’s finally zoom into the warm and comfortable level of humanity. What kinds of cycles do humans and their behaviors exhibit? The way I see it, several cyclical aspects can be seen in our culture. Just a few examples:
1. Fashion: It’s widely believed that fashion trends are cyclical, and trends that were popular when you were younger (bell bottoms, anybody?) can make a comeback decades after being considered quaint and antiquated.
2. Baby names: Just like fashion trends, baby names also wax and wane in popularity. Parents look for modern, fresh and novel-sounding names for their children, which often leads them to prefer names not currently popular, but used to be so decades ago.
3. Life itself: Many prominent global and not-so-known aboriginal communities believe in the idea of rebirth. They see human existence as an endless cycle of birth, life, death, and rebirth.
Quite a whirlwind tour of the cyclicality that pervades our lives, isn’t it? But I’m not done yet: let’s finally turn to what we wanted to examine originally, namely, the domain of investing.
Investing cycles: What you should know
Every investor worth their salt knows that financial instruments, whether stocks, bonds or derivatives, don’t go up or down in a straight line (unless something truly catastrophic has happened, such as a bankruptcy announcement, the discovery of a fraud or just hordes of shiny happy people). Investment instruments typically go up and down randomly while getting from point A to point B, and there may also be periodic “retracements” (i.e. brief reversals of the trend) at so-called ‘support’ and ‘resistance’ levels.
But while these sorts of recurrent patterns might be important for day traders, they’re unlikely to be of great interest or value to long-term investors (barring learning how to ignore them).
So we’ll focus instead on three other key aspects of investing that are cyclical in nature:
1. Business Cycles: Historically, it has been observed that macroeconomic conditions typically change in such a way that various measures of economic activity end up moving up and down in a cyclical fashion. Such a cycle is usually called a business cycle.
Business cycles consist of four distinct phases, with different kinds of investments typically performing in idiosyncratic ways during each phase. These phases are often referred to as the expansion, peak, contraction, and trough phases.
The expansion phase is characterized by a generally bullish outlook, a sharp recovery from a prior downturn, low unemployment, rising GDP and production, a well-performing stock market, and accelerating growth.
Towards the end of an expansion phase, various economic metrics can start to veer into unhealthy territory. Companies might burn through capital recklessly, investors might get overconfident and end up creating a bubble. Moreover, prices can start to rise.
The peak, as the name suggests, is the point where production and prices reach their upper limit. The economic situation then teeters at the edge of a precipice and eventually loses balance, plunging towards contraction.
The contraction phase is the opposite of the expansion phase: economic activity slows down, unemployment rises, and a bearish sentiment can overtake markets.
The trough is then the lowest point, where contraction comes to an end and another round of expansion can potentially begin.
The transitions between these phases can take varying amounts of time, and depend on a wide range of factors, such as corporate performance, ease of access to credit, monetary policy, and the prevailing (geo)political situation.
2. Sector Cycles: There are specific sectors whose performance is known to be quite closely correlated with the state of the economy. Thus, as the economy changes from one state to another, as reflected by the prevailing phase of the business cycle, such sectors will also move along with it, thus constituting their cycles.
Some cyclical sectors are durable goods (including electrical appliances, jewelry, vehicles, and home furnishings), non-essential consumer goods, airlines, and railroads.
Think- when the economy is in trouble and jobs could be at risk, would you spend much on non-essentials? Most of your money will go towards survival, isn’t it?
3. Fund Performance Cycles: Often, you’ll notice that equity funds that had been doing well could start turning stagnant and eventually performance may turn worse.
This happens the other way round too: unheard-of funds suddenly end up in the limelight, topping all performance charts as if out of nowhere!
Why does this happen?
Consider what equity funds are made of. Mostly, stocks of companies (& other instruments). The more concentrated a fund, for instance, if it is a sectoral fund which invests in only a single sector, the more likely that its performance will go up and down, especially if the sector is sensitive to business cycles. Diversified funds will also exhibit cyclical performance and their performance will go up and down, because the stocks they invest in belong to many sectors that may follow (or not) the prevailing business cycles.
And can anyone predict with certainty which sectors or stocks will do well? No. So yes, some funds may suddenly appear fantastic for short periods while some old timers that pride themselves on consistency may suddenly go down the ranking charts. But things ALWAYS turn around. And in both directions. So my advice- choose consistency over occasional brilliance.
Ok, so what do I do with my money?
Begin simply by accepting the fact that there will be fluctuations. And prepare accordingly.
But how does a simple mutual fund investor do that? How can you navigate these cycles skillfully, to try to reduce losses while giving yourself a chance to earn better returns?
Here are four tips:
1. Educate yourself
Learn as much as possible about the sectors your funds invest in. Read up or watch videos on the cycles that they will inevitably go through. Look at historical data and statistics. Have a rough idea of the triggers that can change the phases of cycles, the typical length of each phase, the magnitude of the change in price levels when the phase changes, and so on.
If you study the markets deeply enough AND are an investor with a relatively high-risk appetite, your knowledge of market cycles can let you time your market entries and exits. Easier said than done.
Becoming familiar with these aspects will surely allow you to confidently embrace the inevitability of cycles as part of your investment strategy. This will also make it easier to keep a cool head when a downward phase arrives, and to diversify your investments in a way that may add some resistance to cycles to your portfolio. More on this below.
2. Don't Panic
This is standard advice for life that all of us would do well to internalize. Fluctuations are extremely harrowing, and often lead investors to panic and withdraw their investments at a loss. But if you’ve done the previous step well and your investing decisions were backed by sound research, then you are likely to remain confident even through the ups & downs.
Also, manifest happiness in such times. At least try it.
3. Diversify assets wisely
Cyclicality is predictable, but without knowing when it will happen and in what sectors. Unless you’re a Netra reader, of course! (It won’t tell you everything in advance, but you will have far more insights & clues than most investors)
Therefore, build your portfolio in a manner where you add balance- something that works today in addition to something else that may work tomorrow. Something that adds growth potential in addition to something else that adds a cushion. This can add some immunity to cyclical effects. For instance, you could choose to leave cyclical sectors out of your portfolio altogether, or you could mix in different asset classes that are known to have a roughly inverse relationship with each other, such as stocks and gold.
Remember that all sectors’ cycles don’t work in tandem. So in theory, a well-diversified portfolio will make your investment journey smoother.
4. What goes around, comes around
In life, as in investing, there is the (almost) divine principle of mean reversion. What goes up can come down, and what goes down, can go up. There is a long-term equilibrium state that most things assume over time, and it is quite the same in investing as well.
This is true of equity funds too. The point I wrote about earlier- about equity fund performance moving in cycles can be absorbed gracefully, knowing fully well that things will turn. For better or for worse.
Remind yourself- as an investor, becoming euphoric is as deadly as becoming despondent. Be rational, stay somewhere in the middle of these two ends of the spectrum, and remember to smile while riding the cycle.
Let's conclude with cricket
Consider the cricket teams around the world that have dominated the game over the last 50 years or so. Did the same team always stay ahead?
In the 70s and 80s, it was the West Indian team that was an unstoppable force. Then Australia took over for some time, followed by Sri Lanka (with their incredibly refreshing pinch hitting in the opening overs). Australia then made a comeback again in the late 1990s and early 2000s and remained on top for about a decade. Then it was India’s turn to dance in the limelight. And now it’s England and New Zealand that’re fighting for the top spot. Or which is it? I forget. You know, given the cyclicality. And my bad memory.
The point here is: nothing is guaranteed to perform well literally all the time. Times change, and fortunes reverse. Similarly, if you bet on a single investment, you’re guaranteed to have underperformance more than once in a while. By including some other sectors or asset classes, or types of funds in the mix, you’re basically hedging your bets, and giving your portfolio the opportunity to ‘play consistently’.
Hey, listen. Rollercoasters are meant to be enjoyed. But darega to kaise karega?
The more you understand, the less you fear. The same is true of market cycles: once you know more about them and accept them, you might even start to appreciate what they bring to the table.
Let me finish with what one Mr Louis Pasteur said:
"Chance favors only the prepared mind.”
About the authorThe Rational Ghost. This is one rational storyteller that provides interesting insights & stories about investing and tries to be completely unemotional about it. Lives in the shadows, doesn’t want anyone to know its real name.
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