Market cycles can be erratic and impossible to foresee. A market peak or valley may not be obvious until months after it happens, so it's important to understand market cycles and how they can affect your portfolio performance.
No investment is immune
Every asset class – stocks, bonds, cash equivilents and real estate – can be affected by cyclical patterns. However, different types of investments tend to move in opposite directions as a result of changes in the market. History shows that when stocks increase in value, bond prices typically decline – and vice versa.
Economy and politics drive cycles
Market ups and downs are often affected by economic and political conditions.
- Stock and real estate markets typically do well in a growing economy. Cuts in taxes and interest rates, high employment, political stability and increased corporate profits also can mean rising stock values.
- Bond markets historically do well during times of political uncertainty. Moderate inflation, international conflicts, a volatile stock market and tight money supply often are a boon to bond markets.
3 ways the markets can react
- A correction – A sudden drop of 10% in the major market indexes. After a correction, stock prices tend to more realistically reflect a company's growth and earnings potential.
- A crash – A market keeps dropping, maybe 20% or more, in a short period accompanied by widespread selling.
- A bubble – Overly optimistic investors drive stock prices to unsustainable levels. Although it may take a while, post-bubble stock prices often deflate, giving investors the opportunity to buy at bargain prices.
Another kind of cycle – cyclical stocks
Investments in certain economic sectors typically experience predictable ups and downs because their performance is closely tied to what's happening in the economy.
So-called cyclical stocks do well in a strong economy, but may suffer during an economic downturn. Examples include airlines, housing and automobile manufacturing. Conversely, stocks in pharmaceuticals and utilities are more apt to weather an economic downturn because their products and services generally aren’t tied to the economy.