You Can Time The Market, But Not Always⏱️
You Can Time The Market, But Not Always⏱️
I used to think market timing was selling just before the bubble bursts and buying just before the recovery. That's impossible. It's all about mastering the cycles, which is highly possible!
“You can’t time the market.”
This is the statement you find most of the successful investors like Warren Buffett, Peter Lynch, Bill Ackman occasionally make, and it is true.
However, once you look at the investment history of let’s say Warren Buffett, he somehow managed to be relatively underinvested in most of the big market downturns: Dotcom crash, 2008 financial crisis and Covid-19 recession.
Is he timing the market? Simply no. He just positions his portfolio according to where he believes we are at in the market cycles.
This does one thing: Increases your chance to be underexposed when the bubble bursts so you can buy more later at lower prices. This doesn’t always hold just as everything else in the stock market but increasing your chances is never a bad thing.
When it comes to positioning, Howard Marks is the guy! He wrote two books that changed all my understanding of the markets:
In this post, I will explain how the market works in cycles and how you can see where we are at different cycles so you can position yourself accordingly.
Let’s cut the bullshit and get to the meat of this!
What are you going to read?
Why Do The Market Cycles Happen?
Types Of Cycles
Stock Market & Debt Cycles
How To Understand Where Are We In The Cycles?
How To Position Accordingly?
♻️Why do the market cycles happen?
The American economy literally exploded since the country was founded.
It was a nation of a bunch of liberalists in 1776, then, in an unprecedented way, has become a superpower in just 150 years.
Considering these facts, you would think that the American economy just kept developing in a straight line. That would be a huge mistake.
Just like every other economy, the American economy also had its booms and busts, crises, recessions etc..
Economy occasionally overheats, inflation goes out of control, the Fed raises interest rates, the economy overcools and gets into a recession, Fed cuts rates to stimulate it… This is the basic economic cycle we occasionally go through. There are other and longer cycles too.
The main question is, if the economy is always growing over time, why can’t it grow more like a straight line? In other words, why we must have booms and busts instead of a slow but steady growth.
The answer is simple. It’s actually annoyingly simple: Human nature.
Humans tend to take things to their extreme. You can’t just convince them not to do it. Think about an economy where everything is actually good and the economy is growing. Given that people now have more money, demand is exceeding supply. Managers have two choices, invest in production to ramp up the supply or increase prices. If they increase prices, the outcome is simply inflation. If they prefer to invest and ramp up production, they will also feel the urge to increase prices a little bit to remake the money they invested as soon as possible. The consequence doesn’t change, it creates inflation.
Now that the company makes more money, it pays more to its employees and hires new talent. Those people also now have more money to spend so the price of the products they demand also go higher. Raise the prices, make more, pay more, repeat. This creates an inflationary cycle.
This is inevitable as no human can be convinced to be steady in his demands and no company can be convinced not to adjust prices as demand changes. It just doesn’t happen. Result? Economy overheats, inflation goes out of control and creates the cycle we mentioned.
This is the basic economic cycle and it’s inevitable as long as human nature doesn’t change. And I assure you, this part of human nature hasn’t changed in thousands of years and it won’t change for thousands of years to come.
Result? Cycles are not going anywhere. They happened, they are happening now and they will keep happening in the future.
🔢Types of Cycles
Success includes seeds of failure. This applies to both life and economics.
There is nobody who can manage to become more successful with every step they take in their life. When you become very successful, the bar for success is raised too much that it becomes exponentially harder for you to pass it. This is the seed of failure in success.
When the economy grows so much, it sets a high bar for itself to pass and it inevitably fails to reach that bar. Once that happens, everything is ripe for a recession. Economic growth includes seeds of recession.
It all starts with what’s called the short-term debt cycle.
It is a simple structure.
Low interest rates → More credit → Expansion → Inflation → Higher interest rates → Recession → Low interest rates
As long as the end point of the cycle is higher than the beginning, the economy keeps growing over time.
Think of it likes this:
Economy grows 10% in Year 1
Economy shrinks 5% in Year 2.
At the end of the Year 2, the economy is still 4.5% larger than the beginning of the Year 1, despite the recession. This gives you 2.225% compound annual growth rate.
This is the basic structure of the short-term debt cycle and as I have said before, it stems directly from human nature.
At the basic level, it looks harmless. Basic reading urges us to think like people got some excess money, then they lost some of it but they still have more money then the beginning, right? Not always, not everyone. This is exactly why we have the long-term debt cycle.
In the expansion era, people make money. Some people make way more money than other people. Entrepreneurs going from 0 to a billion dollars are not rare. CEOs, high level executives, doctors, lawyers etc… They all make more money than the average person. During the recession, the same group loses very little of their purchasing power compared to the ordinary people because they were already wealthy.
In short, at time of expansion, risk takers and high earners are rewarded while recessions are taxing especially for the ordinary people. In the cycle, the former group accumulates way more wealth than the ordinary people. The overall growth is not distributed equally.
Given that short term cycles follow each other non-stop, this imbalance in wealth only worsens. Rich get richer, the poor get poorer. Over time, that imbalance reaches a level that ordinary people cannot be relieved off the economic stress by reducing interest rates because they are not the main beneficiaries, high earners and companies are. We reach a point where redistribution of wealth is required. This is exactly where the long-term debt-cycle peaks.
As you see, as the short-term debt cycles follow each other and their effects accumulate, they create a long term debt cycle. When the bubble created by the long term debt cycle bursts, we need redistribution of wealth.
The Great Depression is the most clear example of a turning point in the long-term debt cycle. The US government had to implement structural reforms to overcome the depression.Roosevelt government expanded the Social Security system, adopted minimum wage for the federal government contractors, banks received treasury supervision and suspended the gold standard to devalue the US dollar.
These policies led to redistribution of wealth across the people.
These are the two debt cycles that largely control stock market returns.
📈Stock Market & Debt Cycles
In order to effectively use where we are at debt cycles and use it in our investment strategy, we also have to understand how the stock market acts during the different phases of the debt cycles.
Stock Market in Short Term Debt Cycles
In the short-term debt cycle, the stock market follows the route from optimism & excitement to fear & panic and then it repeats itself.
As the economy grows, optimism is followed by excitement and at somewhere around the peak of the cycle, there is an extreme confidence that the market will go up. Then, as the economic growth slows down, the market declines and fear takes over, slowly turning to a panic. This is the dip of the cycle that usually coincides with a recession. As the government stimulates the economy, panic slowly turns to optimism again.
The important thing is that the extreme confidence and panic usually coincide with the top and dip points of the cycle. This is the theoretical background of buying in fear and selling in euphoria.
Market in Long-Term Debt Cycles
In the long term debt cycle, the market looks like it’s in a long accumulation phase with occasional corrections.
However, when the long-term debt cycle reaches a turning point, negative effects are much longer.
As you see, the short term debt cycle that coincided with the top of the long term debt cycles takes a longer dive down than the other short term debt cycles. This is the prolonged period of economic stress observed after the peak of long-term debt cycles.
After the long-term debt cycle peaked in 1929 and the stock market crashed, Dow Jones didn’t re-claimed its 1929 peak until 1954.
This is why right positioning is of utmost importance to be protected from the negative effects of the long term debt cycles.
🎯How To Understand Where Are We In The Cycles?
How the economy performs reflects most obviously on the business performance.
This is why what’s called “business cycle” largely coincides with the short-term debt cycle.
This is how cyclical businesses perform in a cycle. Their performance recovers in revival phase, boom in prosperity phase, bust in liquidation phase and stagnant in the depression phase, then the cycle starts again with revival.
Revival
Debts are already liquidated, the economy has been depressed for a while and the economic conditions call for some kind of stimulation like interest rate cuts or stimulus packages.
If the interest rates are high, we usually enter this phase 6 months before the anticipated interest rate cuts.
As the expectations for economic recovery get stronger, people start to leave defensive investments and put their money more broadly across the board so the market broadening starts.
Prosperity
The landmarks of this phase are relatively high employment, relatively high GDP growth and ticking up inflation.
Meanwhile, markets generally keep rising to new highs and investors buy in an euphoria. This is when you should look at whether the landmark signs we mentioned are present in the economy.
Liquidation
This phase generally starts when it becomes apparent that some type of cooling in the economy is required.
The landmarks of the phase are shrinking credit and increasing delinquency rate. As the economy cools down, unemployment increases.
Depression
This is where people suffer from the negative effects of the cooling economy. They feel significant erosion in their purchasing power.
Prices and cost of business declines therefore credit slowly starts to grow, ushering the phase of revival.
So, how do all of these fit in the long-term debt cycle?
It’s way harder to evaluate where we are in the long term debt cycle. You have to look at:
How much time has passed after the last peak and burst?
How good are middle-income people doing?
How much do we need welfare policies?
The last one is probably the most indicative. More we need interventionist policies by the government are needed to spread the wealth across the people, the closer we get to the peak of the long-term cycle where we need significant structural reforms to redistribute the wealth.
For the short cycle, you have to look at four main things: Credit, interest rates, inflation and GDP growth.
Interplay of these factors will tell you where we are in the business cycle.
📍How To Position Accordingly?
Positioning for the long-term debt cycle is generally a vain effort as when it peaks and dips is far more unpredictable than the short-term debt cycle.
However, we can position ourselves according to where we are in the short-cycle and try to understand how the big-cycle unravels.
Revival
This phase is characterized by optimism and excitement.
In this phase, you should buy undervalued growth stocks, especially the ones that are cheap relative to the peers. Like Amazon today.
As people gravitate toward the riskier names, this phase generally creates some opportunities in more defensive stocks for value investors, like Ulta today. You should be ready to buy them but also keep in mind that their price can go even lower as people further buy into riskier names as the cycle peaks.
Prosperity
This phase is characterized by excitement and confidence.
Businesses beat earnings and post record revenue growth. Economy looks strong. Stock market looks unstoppable.
This is where people further load up on riskier names. Market P/E is generally way above average. This is where you should switch to undervalued defensive companies. Insurance, consumer staples, discount stores are some examples.
Most people consider switching to bonds but I don’t recommend this. Warren Buffett parks his cash in T-bills because his investable universe is very small. When he sells, he has to wait for something in his investable universe to become undervalued. Your investable universe is immense. You can always find something undervalued.
Liquidation
This is the “do nothing” phase for me. It’s characterized by anxiety and fear.
It’s where most people panic sell or panic buy thinking they see some great opportunities.
You don’t have to swing at every pitch. As the panic takes over the market, the best thing to do is doing nothing.
If you pick your stocks well, you will find this easier to do.
Depression
Panic reaches its highest level.
Generally, great companies sell at huge discounts at this phase.
Remember, in 2022, we could get Google and Amazon below $90. This is where you have to be greedy and accumulate the great & undervalued companies.
🏁Conclusion
Timing when the cycles reach a turning point is impossible, but positioning yourself according to where you think we are in the cycles is possible and recommended.
Once you do that, sometimes you will end up avoiding the bursts and buying just before the recovery starts. This will effectively end up in “timing the market” but it’s not always happen.
A good investor should be aware of the cycles and position himself accordingly. This is essential to maximize the returns and minimize the losses.
You won’t always get it right, but sometimes you will, and it'll be worth it!
Awesome read!
Which indicators do you use to check a stock's cycle?