Predicting the next market cycle
“The problem with putting 2 and 2 together is sometimes you get 4 and sometimes you get 22.”
The capital market and business cycles are highly variable and certainly unpredictable in terms of their duration and frequency. Trying to predict the when and why of either should be done with caution. Yet talking heads throughout the country seemed fixed on predicting the next recession or the next market correction. Very, very few are successful in this endeavor and those who are just lucky. But the history of these cycles can provide valuable insight for the advisor and their clients.
From 1854 through 2009 the average business cycle lasted on average 4.7 years with a standard deviation of 2.2 years. Two thirds of the time the cycle ranged from 2.5 years to 6.9 years. The average stock market cycle averaged 7 years in length with a standard deviation of 3.1 years. This means 32% of the time the cycle was longer than 10 years and shorter 3.9 years. Two important conclusions can be drawn from these simple statistics.
- Trying to predict market turns has significant opportunity costs. If an investor had invested $1,000 into the market for ten years on June 30, 2006, that investor would have earned 7.4% annual compounding during this period. If that same (unnamed) investor had missed the best 10 days of market performance during that 10-year period, the compound annual returns would have been 0.3%. And if an investor had missed the best 40 days during this period the annual return would have been -10.3% (negative). Being out of the market for only a few days over a long-time span has powerful implications for return results and client goals.
- Gauging the results of managers over short time periods is futile and contains very little information about the manager’s skill or future potential. Because of cycle volatility and length, making investment decisions based short term performance mismatches the time horizon of most client objectives. This mismatch usually leads to turnover cost and takes on the opportunity risk mentioned above.
Investors need help making investment decisions and rely on financial professional to provide sound and proven advice for these decisions. The history of market and business cycles can provide valuable clues to capital market assumptions and how they are changing. By understanding these shifts in various drivers, better decisions can be made for the client. These decisions should not be based upon predicting market cycles because of the difficulty in doing so and managers should be evaluated over longer periods of time that coincides with factors affecting the current cycle.
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