A question that has plagued investors, shareholders and brokers since the dawning of the market, is whether any cycles exist that might help them to predict future activity. Since the time of the Old Testament, business cycles have been documented – but is there any real truth to their existence, and more importantly, do they possess any usefulness?
What is a Cycle?
In its most basic form, a cycle is a chain of events that repeats itself over an estimable time. The outcome need not be identical on each occasion, but events will share many similar characteristics.
One of the most easily understandable examples of how cycles work is the seasons. Each year, summer follows spring, autumn follows summer, and winter follows autumn. We know that this will happen, and we can assign typical behaviors to each quarter, such as colder winters and warmer summers. However, not every summer will be exactly the same, despite each of them being the same phase of the seasonal cycle. Factors such as temperature, rainfall and humidity may all vary to quite a dramatic degree year-on-year.
Why do Cycles Matter?
With regards to the stock market, cycles are highly important. They indicate patterns of behavior that will be repeated, thus offering an insight into how future markets may perform. Longer-term cycles give us an indication of upcoming market trends, whilst short-term cycles can be used to identify strategic entry and exit points from the stock market.
The Kondratieff Cycle
We know that business and economic cycles have been in existence since at least the time of the Old Testament, where a 50-year cycle is referenced.
The most famous economic cycle was identified in the 1920s by Russian economist Nikolai Kondratieff. Kondratieff studied wholesale prices, interest rates, wage levels and production indexes from the period 1780 to 1920, and found a cycle in the western world that lasted between 48 and 60 years.
In his paper, ‘The Long Waves in Economic Life’, he identified five distinct phases:
1. The First Decade, a recovery period
2. The Second Decade, a boom period
3. The Third Decade, the peak and a transition period
4. The Fourth Decade, economic collapse
5. The Fifth Decade, the trough and transition period.
Opinions and statistics suggest that the western world is currently in the Fourth Decade – a period of collapse.
Does a Stock Market Cycle Exist?
There are two primary models on the existence of a stock market cycle. The first is that of Edward R Dewey, who used data stemming from the 1830s onwards in the formulation of his theory. In his book, ‘Cycles’, he proposed that a 9.225-year cycle exists within the stock market, with only a 1 in 5,000 chance that the documented patterns could be down to pure coincidence.
Stock market cycles have also been identified by Veryl L. Dunbar in 1947, who suggested that a 46-month cycle existed, and John Hurst, who identified 12 dominant cycles within the stock market.
For a better understanding of market cycles and how they might influence your investment choices, take a look at this video from Killik & Co.
When it comes to making an investment, it is impossible to predict with 100 per cent accuracy how the market will perform. There will always be risks involved in investing capital in an unknown entity, but do your research, and at the very least you may improve your chances of investing successfully.