This article explores the importance of understanding economic cycles when analyzing markets from a macroeconomic perspective. It outlines a framework for interpreting economic data and making informed investment decisions, emphasizing the significance of the U.S. market within the global economic landscape.
Why Focus on the U.S. Market?
Many wonder why the channel focuses so much on the US market. Even if you don't invest in US stocks, it's crucial to understand its influence. The U.S. plays a dominant role in the global economy and financial markets.
-
Global Market Weight: The U.S. constitutes a significant portion of global equity and bond ETFs. For example, US stocks represent over 60% of the VT global equity ETF and half of the BNDW global bond ETF.
-
Dominant Corporate Presence: The U.S. is home to a large number of billion-dollar companies compared to other countries.
-
Key Economic Driver: The U.S.'s economic performance significantly impacts other markets due to its strong political, economic, and military power, technological leadership, robust consumer spending, massive financial markets, and the U.S. dollar's role as a primary global reserve currency.
-
Global Impact: A strong U.S. economy benefits other nations, while a struggling U.S. economy can negatively affect the global economy.
-
Market Leadership: Historically, the U.S. market's trends influence global stock market movements in the short and medium term, with non-U.S. and emerging markets sometimes exhibiting a seesaw relationship with U.S. equities in the long term. The U.S. economy's cycles drive global capital flows and development.
The Essence of Economic Cycles: Mean Reversion
The core of economic cycles is the concept of mean reversion. These cycles, encompassing economic booms and busts, stem from human behavior and the continuous oscillation between optimism and pessimism.
-
Human Emotion: Sentiment often overshoots, with excessive optimism during economic booms leading to increased spending, risk-taking, and debt accumulation.
-
Corporate Response: Businesses react by expanding production and lending, creating a positive feedback loop.
-
Inevitability of Reversal: This upward trend is unsustainable and eventually reverses.
-
Market Dynamics: Financial markets mirror this pattern, with rising stock prices and increasing leverage ultimately becoming unsustainable.
Types of Economic Cycles
Economists have observed cyclical patterns for centuries. The channel primarily focuses on three types of cycles:
- Manufacturing Cycle (approx. 3 years): The shortest cycle.
- Business Cycle (7-10 years): A medium-term cycle influencing broader economic activity.
- 30-Year Cycle: A long-term cycle combining a roughly 20-year productivity cycle and a 10-year inflation cycle. This is integrated based on Aisherk's theory.
The presenter advises readers to study Aisherk's three books.
Cycle Interplay and the Layered Approach
Economic cycles are interconnected and not independent.
-
Human Nature as the Root: These cycles stem from human behavior and are difficult to disrupt or reverse. External factors may influence their duration, but the underlying trend remains.
-
Manufacturing Cycle Impact: In the past, manufacturing downturns in the US caused recessions.
-
Overlapping Cycles: Money is finite, so the cycles interact, with larger cycles having more significant cumulative effects.
-
Hierarchical Structure: Think of the cycles as ocean waves: tides (30-year & 7-10 year), waves (3-year manufacturing cycle), and ripples (shorter-term fluctuations).
-
Trading Strategy: The channel's market commentary focuses on wave-level trading based on the manufacturing cycle.
-
Matching Timeframes: Understanding the cycle hierarchy helps align investment strategies with appropriate time horizons and reactions to market changes.
Historical Perspective and Market Corrections
The magnitude of market corrections is often linked to the scale of the underlying economic cycle.
-
Mid-Cycle Corrections: When only the manufacturing cycle is in a downturn, the resulting market correction (a "mid-term correction") typically sees the S&P 500 falling by approximately 15-25%.
-
Intermediate Recessions: If both the manufacturing and business cycles decline while the larger 20-year productivity cycle remains up, the S&P 500 may experience a decline of around 20-35%.
-
Major Bear Markets: When the large cycle also declines, creating alignment among the big, medium, and small cycles, major bear markets with significant declines (around 50%) can occur.
Current Market Position and Future Outlook
We are currently in the second business cycle of the productivity cycle.
-
Current Stage: The current manufacturing cycle is likely the last cycle in the ongoing business cycle.
-
Potential Shift: After this cycle, both the 7-10 year business cycle and 20-year productivity cycle may end.
-
Late-Stage Cycle: We are in the final 1/5 to 1/6 of a 20-year uptrend.
Applying Cycle Concepts to Investment Strategies
It's crucial to avoid blindly applying others' strategies. Understanding "what others are saying" and "knowing what you are doing" is critical.
-
Investment Goals: Understanding cycles offers insight into potential risks, your current market position, and implementing a "long-term protection for short-term" strategy.
-
Limitations: Cycle analysis cannot precisely predict short-term market movements.
-
Long-Term Perspective: Focusing on long-term trends helps investors weather short-term volatility.
-
Strategic Preparation: Knowing the cycle's stage allows for informed preparation for potential market fluctuations.
-
Ignoring Short-Term Noise: A long-term perspective enables investors to disregard short-term market noise.
-
Cycle-Based Investing: Cycle-based investing prioritizes long-term gains and increased tolerance for risk.
-
Gradual Adjustments: While operating on the manufacturing cycle, gradual adjustments are applied.
In conclusion, understanding economic cycles requires recognizing the big picture and layering a framework. This understanding allows for the development of effective investment strategies.