Understanding Stock Market Boom and Bust Cycles

By June 27, 2019

Stock market boom cycles and stock market bust cycles are recurring periods of economic expansion and contraction. An economic expansion is a boom, when the economy grows, jobs are abundant and stock prices are rising. An economic contraction is a bust, when the economy shrinks, jobs are lost and stock prices crash. Hence the saying, ’what goes up...must come down’. Well known examples of periods of economic expansion and contraction include The Great Depression (1929-1939), The dot.com Bubble (1994-2000) and The Great Recession (2007-2009).

The Economic & Stock Market Cycles

There is a high correlation between economic cycles and stock market performance. As the economy goes bust, the stock market typically crashes. When the economy booms, the stock market typically bubbles. The relationships are dependent upon each other, with movements up in the stock markets leading signs of economic improvement and movements down in the stock market leading signs of decline in the economy.

There are four stages in the economic expansion and contraction cycle and these four stages have a direct relationship to the stock market’s boom and bust cycle. The first stage is expansion during which interest rates are relatively low and production is increasing. This usually results in lower unemployment numbers and a rise in inflation. During the economic expansion stage, the stock market is rising as companies borrow capital to increase production capabilities and demand for goods and services increases. With continued strong consumer demand stock prices will continue to rise and the economy will continue to improve, leading us into a stock market boom.

Now we’ve reached the second stage or the peak of the economic cycle. This is a time when economic data is strong as production and growth are at maximum capacity, economic data is good and the stock market soars. However, as the increase in production catches up with the demand for products, companies wind up with a surplus of goods. The over-production of products eventually results in a supply imbalance in the economy. At the same time, inflation becomes a concern and interest rates are increased thus making capital more expensive which usually leads to an economic and stock market correction.

This correction is the third stage during which production and growth slow down, employment data weakens, sectors and business fail, debt has risen and interest rates are cut. During the economic corrective stage stock market prices decline, but if economic data improves the corrective stage is relatively mild and short lived. If the economic data declines and supply exceeds demand, a crisis occurs and the stock market goes bust.

A stock market bust leads to the fourth and final stage, the trough stage in the economic cycle. In the trough stage, the economic data is very poor and there is a depression or recessionary environment impacting businesses and consumers. At that point, interest rates are lowered, setting the stage for a recovery to begin a new cycle. During the trough stage, both the economy and the stock market bottom out.

Portfolio Management in a Stock Market Boom Cycle

There are economic and stock market patterns that can help traders and investors anticipate changing stock market cycles. During the expansion and peak stages of the economy, the stock market has bullish patterns and uptrends with rising prices as demand exceeds supply. Recognizing these bullish patterns and strategically planning to reallocate during this peak stage could protect stock market gains during this period. Regular reallocation during this stage could help improve the rate of return. Since the trough in 2009, the economy has expanded and the stock market is booming, as can be seen in the chart below. As of the date this article is written, the stock market is trading at all-time highs, the longest sustained bull market (also called a super boom) in an economic expansion ever in history.

A trading strategy during a boom could consist of taking a long term position in the market to potentially take advantage of the high rate of return opportunities while still managing risk. Rates of return will, of course, vary; however, consider the annualized rate of return during the expansion stage since 2009 throughout this current super boom stage. In 2009, the S&P 500 gained 25.94% and in 2013, the S&P 500 gained 32.15%. Passive investors could reasonably hold long positions until the supply formations of the peak stage appear, at which point they would want to take measures to protect the nice returns that they’ve made. Active investors could manage long positions during these stages by using stop losses that trigger when supply formations occur; this has the potential to change the risk to reward ratio. There are a variety of products to use to position long the S&P 500, like the Exchange Traded Fund (ETF) SPY, call & put options on SPY, and the futures contracts of the S&P 500.

Portfolio Management in a Stock Market Bust Cycle

During the corrective economic stage, stock market price exhibit bearish patterns and down trends with declining prices as supply exceeds demand. With the right education, recognizing these bearish patterns and strategically planning for the correction could help prevent catastrophic losses. If economic data does not improve during the correction and the stock market continues to decline, the reallocation done during this stage of the cycle could minimize overall stock market losses.

For example, when the stock market peaked in 2007, recognizing the early signs of the correction with bearish price patterns as the stock market turned down prepared some investors for the crash.

Trading strategies during a correction could consist of taking a short-term position with investments, targeting a rate of return while managing risk. The worsening economic data lags the bearish stock market patterns during the correction, creating the appearance that all of a sudden the economy collapses and the stock market plummets, which then leads to the trough stage.

In addition to taking shorter-term positions during a stock market correction or crash, bonds tend to be considered a safe haven in a weakening economy and stock market downtrend. As depicted on the chart below, from October 2007 to January 2009, the S&P 500 declined 46% while Ten Year Treasuries rose 15% over that span of time with a peak of 32% in 2008.

Shorting stocks, ETFs, stock index futures and using call and put options is another popular bear market strategy. Not to be confused with taking short-term positions, meaning the duration of the trades are shorter; shorting the market involves selling stocks with the intent of buying them back at a lower price when the market drops.

Anticipating Stock Market Cycles

The stock market boom and bust cycles tend to lead economic cycles because the economic data takes weeks and even months to calculate and analyze. Understanding the relationships between the economic expansion and contraction cycles and stock market boom and bust cycles could help determine what decisions to make and when.

At Trading Academy, our step-by-step Core Strategy is designed to help people learn to identify the supply and demand imbalances that could give us an indication as to when a stock market boom could be turning into a stock market bust.