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Economic cycles: what they mean for traders

09:08, 10 March 2022

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As 2018 turned into 2019, there was much talk of a turn in the economic cycle. Share prices ended the year down and many said the long bull market was over.

True, there was some doubt as to when the bull started running: 2009, 2001, 1985, and other candidate-years. Nor was there consensus on the cause of the demise (if that is what it was) of the sustained upswing in asset prices.

Was it the end of the extraordinary stimulus that had pumped cash into the economy and on into share prices? Was it the threat of a trade war between the US and China? Or of a collision between Italy and Brussels over fiscal policy? Or issues around Brexit? Perhaps potential confrontation between Russia and the West was to blame?

The business cycle

Those who look to the economic cycle as an explanation do not necessarily dismiss any or all of these suggestions, but they believe underlying causes are far more decisive in moving the market and changing long-term trends.

As a trader, how ought you to navigate these economic cycles? Indeed, what exactly are they?

The first key point is that not only are there different types of economic cycles but that there are those who doubt they exist at all.

Perhaps the closest pattern that comes to common acceptance is the “business cycle”, also known as the inventory cycle or the Kitchin cycle, after the statistician Joseph Kitchin. This is the shortest of the cycles and is generally thought to last for about four years.

It is also the easiest economic cycle to understand, given the factors behind it are straightforward. In essence, the economic cycle begins in an “up” phase, with a balmier commercial climate persuading businesses to expand production and payrolls.

Initially, all goes well as firms meet customer expectations, and those customers are prepared to pay the prices for goods and services that had persuaded businesses to expand in the first place.

However, the economic cycle turns as markets are glutted and inventories of unsold stock build up, alongside excess capacity for services. Prices fall, and firms retrench to bring supply into line, once more, with demand.

A time to go bearish

Sharp-witted traders ought to have relatively little difficulty in handling the business cycle. Study the news for signs of excess capacity building up, whether in chain high-street restaurants, in hotels or in electric cars and swanky riverside apartments, and trade accordingly.

The turn in the business cycle is an opportune moment to go short, thus anticipate market disappointment when this turn becomes apparent.

While not enjoying the consensus support of the business cycle, the Juglar economic cycle is widely recognised as having an observational reality. You will hear from time to time that some sort of recession, however mild, occurs about once every nine years, and it is to the Juglar economic cycle that this refers.

Over-investment creates excess capacity in what amounts to a larger version of the business cycle, and that capacity will need to be excised at some point, bringing the cycle to a close.

In general, a trader spotting the imminent end of a Juglar economic cycle will go bearish. A more sophisticated approach, albeit one with greater risks, would be to try to spot which firms will be most likely, in the jargon, to “leave the line”, in other words to cut their losses and pull out of a glutted market.

When a downturn strikes, all firms in each sector will be hoping their rivals are the first to fold, leaving more business to be shared among the survivors. Successful traders will try to identify winners and losers ahead of the event and deal in the market accordingly.

So far, we have been looking at economic cycles whose existence is broadly accepted. From now on, the business of cycles becomes murkier and more controversial. It becomes also considerably vaguer in terms of timings.

The Kuznets cycle – named after the Nobel prize-winning economist Simon Kuznets – may last between 15 to 25 years, meaning the margin of error is about the same length as an entire Juglar economic cycle. Kuznets based his observations of demographic change and its effect on construction and other activity.

Traders may prefer to confine Kuznets and his ideas to their off-duty reading rather than to try to incorporate them into market strategies. But it is worth noting that real-world patterns suggest there may be something in it.

The long wave

The golden post-war boom came to end after about 25 years, in the early seventies, and a second upswing lasting another 25 years, from the early eighties to the crisis of 2008. Ten years on from that crisis, real incomes in the UK are finally growing once more, suggesting another upswing may be imminent.

Any trader planning to follow a Kuznets strategy needs to be very sure of their ground, lest they load up on construction stocks (or go short on them) at precisely the wrong time.

Finally, there is the “long wave” cycle, named after the Soviet economist Nikolai Kondratieff. Each wave is said to last anything from 40 to 60 years and to be initially powered by technological innovation, such as steam or electricity, the impetus from which fades towards the end of each wave.

Very many economists dispute the existence of long waves, and their length means they are of little use to traders. They can, however, stimulate thinking about trends that may bear more immediate fruit for the trader.

It has been said that the lax monetary policies introduced after the financial crisis have abolished economic cycles, even the short business cycle, by keeping economies growing at full tilt. More likely is that they have elongated wave patterns and postponed downturns.

Finally, remember that the shorter cycles fit inside the longer ones. Thus, roughly two Kitchin cycles fit inside one Juglar cycle, and an average of two Juglar cycles fit inside one Kuznets wave.

It is fair to say that the longer the cycles being proposed, the less clear and convincing they become from a trading viewpoint. But that economies ebb, and flow is beyond question, and good traders will want to make this process work for them.

Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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