The anatomy of a market cycle

by Nandan C – ET BB

The first step in understanding market cycles is realising that it is primarily driven by liquidity cycles, which are only partly related to economic cycles.
Liquidity could be driven by increased economic activity, or due to decreased appetite for real physical investments or consumption. Liquidity cycles typically lead economic cycles.
There are myriad ways to track the market cycle. One is the changing valuation paradigm, from liquid investments, to dividends, to earnings growth, to relative P/E, to expansion opportunities, and finally to unlocking of ‘hidden’ asset values.
Related to this is the stretching of forecasting time horizons. Another way is by tracking the level of knowledge dissemination and interest in stock markets, including inflows from other asset classes — from specialists, to institutions, to media, to retail, and finally to those earlier uninterested in markets.
A third way is tracking increasing level of investments, both physical (capex) and financial (IPOs). There is another way used by experienced investors only, i.e. asking oneself: “
Am I feeling blue skies above, or is my current state of happiness slapped by cloudy fears?” If it is still fearful, for economic or other reasons, it is possibly not yet in the last stage. The danger in analysing all these levels of market stages, including the last two mentioned above, is that at any peaking stage, looking backwards, things will seem to have moved to the last level, rather than just the next level. Nobody has yet found the final solution to determining the last peak.
Any type of event shock may trigger the final blow-out, for example, a scam, a big bust, or a major crash in an economic parameter. But these are only non-forecastable triggers and should not be confused with causes.
The most practical solution for the average investor in this quest is not to try judging this last peak, but to pay taxes. He should get out before intermediate peaks — which are more easily determinable from some of the above analysis — and re-enter at higher levels, when he’s convinced that it is just the next stage and not the last. The most important thing to do during this journey is to allocate lesser sums at each rising stage.
Now, after a bull peak, how should investors track the corrective phases? How do they know when it’s best to buy? After all, more money was lost in the 1930s averaging down, than in the crash of 1929 itself. Truly experienced investors look within and figure out what emotional stage they are in, i.e. have they reached the disgust stage yet? Recall Kaffka’s ‘Metamorphosis’ where a family member transforms into a giant cockroach.
The emotional stages of other family members transform in stages, from fear, to helping, pity, shame, and finally to apathy. So, too, the correction proceeds in stages, from need, to liquidate (redemptions/borrowing costs), to greed, to fear, and again to liquidate (meet financial needs) and finally to disgust/apathy.
You may have noticed that most of the above signs of peaking were already evident through the past few months. So a sharp correction was anyway due, especially as the rise had no resting periods. With this basic understanding of market/liquidity cycles, let us proceed to the central question today — is the next stage a continuation of the bull run or the start of a long bear market?
Firstly, global liquidity flows into equities continue to be driven by eco-political compulsions across the globe, including managed currency regimes. At rising interest rates and asset values, other asset classes are relatively not more attractive today versus equities. Of this burgeoning global equity pie, the allocation to emerging markets (EM) remains fundamentally more attractive versus an ageing and slowing developed world.
Of this EM pie, India will continue to enjoy a valuation premium over most other emerging markets due to its growth, demographics, governance, transparency, and its lower dependence on externalities, like trade/commodities. However, some of this premium may decrease if there is a resurgence in Chinese growth.
This may become worse if there are political mind-bends in India due to misallocation of financial/intellectual capital. Hence, liquidity is likely to return to India, though the valuation premium that India enjoys could decrease.
Even moderate price increases in oil, interest and inflation do not affect the Indian GDP growth substantially. However, they do affect liquidity flows. The global layman feels richer (wealth effect) and puts more money into equities if, say, property prices rise, or interest and currency rates change the hurdle rates of borrowing monies to invest in India. Globally, very large increases in oil/interest/inflation may not be allowed to take place by powers who will be hurt far more than India.
In short, Indian fundamentals haven’t worsened in any way and growth looks quite robust. Liquidity will insist on returning. It is unlikely that the liquidity cycle which drives the market predicts a bear market start today.
So, what should one do now? The worst may not be over.
We may have one more up-wave and down-wave before a rejuvenated market cycle. Hence, use this rally to sell your junk stocks and buy robust growth-oriented stocks, where earnings growth is clearly visible. And when the disgust stage comes, buy value stocks at high margins of safety. And if that doesn’t come too soon, you are happier owning the growth stocks anyway at today’s prices. Don’t try guessing the last 10% of the market — whether at the tops or bottoms — in duration or extent. So use logic, not emotions, in following a good investing discipline.
(The views expressed by the author are personal and do not reflect those of his employer)
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