Deeper anatomy of cycles

 

Deeper anatomy of cycles

The introduction briefly discussed the anatomy of cycles and found that the main directions of economic cycles were ascending. In the long run, growth is steady, but in the shorter ones it fluctuates around a long term growth rate. For example, the average growth rates of developed economies are about two percent over decades. Annual growth can be well above that or go negative. Almost all cycles exaggerate the lengths of both their ups and downs and the pace of change.

Defining stages is not rocket science. All stages are not inevitable but also necessary. No precise scientific definition has been made. It is up to you how you define the different stages of the cycle, but I personally use the following stages:

1. Rise after reaching the bottom
2. The peak
3. Decline after peaking
4. The bottom

The rise starts from the bottom, pointing upwards past trend growth towards the top. That is the slowest stage. The duration is often multiple compared to the decline. Long cycles can last decades and medium ones from a few years to a decade. They do not mean continuous upward movement but may include both lateral movement and shorter descents. The annual rate of increase on the basis of the peak exceeds the average trend growth. This is not to say that the rise in individual years could not be slower than the trend between bottom and peak. The rise is usually the fastest after the bottoms and before the peak. Long cycles almost always rise higher than previous peaks.

The lengths and durations of the rises depend on the bases and declines of previous cycles. The lengths of the cycles and their phases cannot be known in advance. Mass psychology is unpredictable and the size of madness or reasonableness cannot be predicted in advance. They cannot be determined by mathematical formulas, even if attempted. Share prices, real estate and commodity prices do not follow pre-defined limits. They can multiply in a short time or drop more than 80%. The best examples of the above are the sevenfold increase in the Nikkei Index in 1980s Japan and the more than 80% decline in the Dow Jones Index from 1929 to 1932. Investors with bad timing will never get their money back. This is true at least in Japan where previous peaks have not been reached.

During the ups and downs, positive emotions and negative emotions like jealousy become stronger. The latter is most evident in the minds of outsiders. Emotional states reinforce themselves until they are close to or at their extremes. In addition to jealousy, positive psychological factors are at their strongest point towards the end of the upswing. The factors are e.g. social proof, the illusion of availability, the illusion of scarcity, and new, old displacing authorities. The number of people staring from the side and suffering from envy is at its highest. Many of them think, "How can a neighbor's fool, John Doe, be able to make that much money, even if he doesn't understand anything about investing?"

Social proof is at its highest, with the largest possible group believing that they will get rich with little effort because others around them believe the same. Everyone is starting to get tips from their environment. They can come from neighbors who have never invested but have started making money. They can also come from co-workers or close relatives. The availability of positive signals from elsewhere is increasing.

The end of the ascension also brings forth new, old substituting authorities. In this case, you will find several new investors who have made a lot of money. The general public is starting to listen to them, even though their success as investors has only lasted a few years. Old authorities that have succeeded in the market for decades are ignored as having seen their best days, as senile, as incomprehensible about the new economy, and as longing for the past. Without their warnings, the enthusiasm created by the positive factors would be smaller. Most of the time, they’re finally right, even though some of them are trying to make money in the final moments of the rise. In particular, central bankers and other regulators need to be silent if they are not prepared to act at the same time. Without action, they will allow investors to do stupid things because they show acceptance of high prices.

The further the ascent progresses, the more creations of financial engineers will appear. There is always a new popular investment vehicle that is a new form of “alphabet” (SPAC, MBS, CDO, etc.). What they have in common is complexity. Some of them can only be described with reports of thousands of pages. They are usually combined with hundreds of junk papers that no sensible investor would buy individually. They are sold as great investments. Even credit rating agencies cannot or will not have time to go through the content properly. In other words, they are classified as safer than what reality ultimately tells us. The pile of crap is always crap, even if it is coated with gold or has a great name.

They can be considered obvious scams and they are, but the big boys mostly survive with remarks or small fines compared to the damage done to customers. The caravan passes and the million-dollar bonuses move. They recommend investment vehicles even when they themselves are selling as fast as they can without crashing their price.

Market peaks are not always a single spike up, followed by fast decline. A larger decline may begin much later. Bankruptcies or forced sales of new market gurus must be seen before the big fall. The peaks include excessive lending and borrowing, the apostles of the new economy, the growth of economic scams, etc. The intensity of the peaks varies. In developed economies, the peaks of cycles are often the result of euphoria or bubbles, depending on what designation you want to give them. In them, nonsense goes further. I'll come back to the bubbles later.

The falls are faster than the rises. A decade’s rise usually causes a few years of decline, but it can be faster. The duration depends most on the previous peak and the resulting rise and the reasons associated with it. The more exaggerated the peak, the longer the decline, at least in terms of length. In most cases, the decline is below the average trend line. The decline may not be prolonged over time. The signs of the start of the invoice are e.g. the departure of the apostles of the new economy to the rear left, the increase in the mention of financial scams in the press, the revelation to the general public of the weaknesses of the new creations of financial engineers, etc.

During the descents, negative emotions and joy of harm become stronger. The latter is visible to non-market participants. The “what I said” reaction is most common near the bottom. The bottoms also contain an increasing amount of bankruptcies. Panic describes the mental state of several actors, although the situation does not get worse. The situation is escalating rapidly, but the worst is passing by.