Behavioral finance FAQ / Glossary (Cycle / Cycle-trend)

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Year/month, d: developed / discussed,
i: incidental

Cycle / Cycle-trend

08/2i + See trend, bubble,
extreme, bandwagon,

momentum, overreaction

Up and down, up and down.
Enjoy the market ride!

Swinging from pheasant with truffles
To chicken wings with ketchup.

And back.

Market cycle definition:

Business cycles, as well as asset market cycles, are
alternating phases of rises (expansion) and falls
(contraction) in volumes, prices and returns.

Cycles and trends

Markets are lands of hills and canyons
Be well equipped to cross it!

Economic growth as well as financial market evolutions are rarely linear
(in the sense of continuous,
see nonlinear).

The economic / financial fluctuations can occur in several ways:

* nearly permanent minor vibrations,

* sometimes sudden hiccups or jumps.

* and even rather long periods of fat cows and others

of skinny bovines, as prolonged rising or falling phases.

=> Let us focus on those long upside or downside periods

Those waves are usually called trends
(see that word)
.

They last at least several months, and
typically several years
(*).

(*) Even several decades, when talking about "long cycles / long
     trends".

     They might be linked to
      - deep historical technological upheavals,

     - social evolutions
     - and changes in economic paradigms.
    
     They also include several shorter cycles (subcycles) .

After a while, at least as concern financial markets, a trend gets often out of
hand and leads to excessively low or high prices (see extreme), until
it reverts to the opposite trend, let us swing, baby !

What is fattening or starving the financial bovines?

There are many reasons for those important,
and sometimes extreme, swings:

From "hard" factors (unbalances) such as

Technology upheavals,

Natural and human resources availability,

Monetary and industrial / commercial phenomena (detailed
    below)


To "soft" ones (economic player behaviors)

such as alternating behaviors in borrowing / spending / investing 
that mirror attitudes and expectations varying from
exuberant
hope to excessive fear.

A matter of time


Cycles differ from disruptions that instantly adjust prices.

The investors' optimism (the "parachute of hope")
or pessimism (the "wall of worry")
takes time to
disappear, to fall from 80% to 20 % of the population.

This long delay is needed to heat, overheat and block the engine, and for a
trend to start, develop, reach extremes and...cease, for the next trend to start.

This is the under-reaction / adjustment / overreaction chain
(see those words).

Statisticians found that an asset or market that has shown an impressive
rise or fall in a previous year
has a high chance to do the
same (persistence)
in the following year
(see momentum effect, bandwagon).

It might reflect economic value evolutions, but also simple market mimicry /
herding

=> Thus it often leads after a while to a growing discrepancy between prices
      and 
"fundamental values", with a violent correction and trend inversion
      after several years.


This is the glory and danger of momentum trading / trend following (see
those phrases).

You can gain a lot when riding the bandwagon and lose even more when it
reverts its course.

When violent crashes interrupt fhe dance :

At the end of an uptrend, the downside correction

*  not only tend to come late, as the  imbalances (i.e. a general 

   overleverage and / or overpricing) take time to be
 
recognized as anomalies.

* But also do not "purge" fully and immediately the market mispricing.

 Actually the "corrective" new trends persist often until the mispricing goes
 to the
other extreme (see under- / overreaction), sometimes ending in a
"capitulation" (see that word) 

Cycles vs. randomness and volatility

Market moves do not seem to be due only to the dice, as
dice stick to randomness
and ignore market sector
rotation.

Those alternations are more than simple random
accidents
and are not fully explained by the "random walk hypothesis" (see
that phrase).

What contradicts randomness is:

The persistence of those upwards or downwards trends,

as they can last for months or years.

Their repetition: after one up-and-down cycle, another
   starts again.

The wheel revolves on and on, although irregularly.

In asset markets, those evolutive traits are sometimes called
cycle-trends or momentum cycles.

Some see cycles affecting asset market prices, as

"medium / long term volatility",
with just a difference of scale between short and medium / long
variations.

This is seen not only in market price evolutions but also, more
generally, in many dynamical system that fit fractal charts.


However irregular are their amplitude and duration,
there is no problem to use the "cycle" word.

But determinist mathematical functions should not be pushed
too far to describe phenomena in which human behaviors
play a part.

Can those fluctuations really be called "cycles"?

Markets do not seem to exactly ride
the
pian-clk.gif clock needles either.
Whatever the cycle mystique.


Although commonly used, the "cycle" word is rather a misnomer.

To label those phenomena as cycles would mean a perfect
clock-driven (*) (**)regularity of occurrences, amplitude and timing.

It is not the case, as those economic or financial "fluctuations" or
"alternations" are most of the time rather irregular (although
not completely erratic)

Their magnitude, length and shape never repeat 

exactly,nothing like the seasons of Earth orbiting around the Sun

There are also asymmetries of lengths and sizes
    between rises and falls: often the rise lasts longer than the fall,

although the contrary can happen also.

=> Thus, some prefer to call them aperiodic cycles or near-cycles.

      Markets have irregular heartbeats.

(*) Beware of some mystical approaches that see universal

mechanical regular rhythms behind market cycles in particular
and social evelutions in general.

Everything goes in investment theories, including mysticism
(see that word).

Some see repetitive waves that would be related to golden
numbers and universal cosmic laws.

Those believers brought their own esoteric / numerological /
cosmological
visions (Elliott, Gann...), sometimes under a
label adding a scientific aura (socioeconomics...).

(**) Some see here an intermingling of different cycles that
        complement
or oppose each others in amplitudes and lengths.

They also have their own subcycles.

On a chart, the whole agitation would show multi-fractals (see
fractal).

What causes asset market cycles?

What fattens or starves the financial cows?
The state of the economy?
Or the investors' mood?


No asset market cycle is exactly identical to another.
Even the word "cycle" is not fully relevant as seen above.

The causes of "cycles" could be sorted in two kinds,

1) Fundamental factors (economic unbalances):

Money supply and interest rates
                                      variations,

Mismatches between production and consumption 
    (and resource availability),

Technology changes,

Competitiveness problems or progresses, etc.


Those economic phenomena are:

"Mechanical" - or, a better metaphor, "hydraulic" 

  like problems of underflows and overflows in a bathtub.

  Some might even see just a general statistical law of
  "regression to the mean"

But also caused by behavioral factors affecting the economic 

players: producer and consumer expectations, sentiment and
behaviors...

2) Alternations of extreme collective investor
    expectations and behaviors

Those factors are financial market traits, not always related to
economic situations.

See "bubble and crash", "herding", "greed and fear",
and many other articles in this glossary.

* In some cases only one of those kinds of causes is at play,

* in other cases they coexist or follow each other, showing some cross-
   influence.

A typical case: stock market cycles

Slow dancing with some partners,
fast swinging with others.


Stock markets are typical places to see such irregular alternations of bull and
bear trends
/  waves.

Also, they imbricate irregular sub-cycles of different lengths.

Here are some asset / stock market cycle traits:

Length:

The stock market history shows a combination of
pian-clk.gif short and long price cycles.

They last several days, months, years, decades or even
generations
(secular cycles).

Also fractal theorists see here - maybe a bit too systematically -
an intermingling of several long cycles, and of all their sub-cycles
(multifractals)


Scope:

Cycles might differ between asset classes, sectors
or even
individual assets.

Every asset sector, and as regards the stock market each
industry or stock
type, catches the investors' attention in its turn,
in a kind of market rotation (see rotation).

This either reflects fundamental motives or occurs because
investors follow fashions.


What is affected:

Those alternations affect as well prices and
returns as volatility.

The volatility range usually widens in periods of high uncertainty,
often linked to bear markets; and recedes and stabilizes later
(see heteroskedasticity).

How far-reaching is the cycle phenomenon?

Financial market pulse?
Or general economic and social beat?


Cycles-trends
causes and effects:

Are sometimes limited to the financial sphere.

At other times, are correlated to larger socio-economic
  
unbalances (business cycles).


The correlation in timing and amplitude between those two kinds of fluctuations,
the financial ones and the economic ones, seems to be loose (lead-lag effect:
see hysteresis), and in some cases non-existent (complete disconnection).


Another thing is that financial cycles are about prices while prices in business
cycles are only one variable among others (i.e. volumes of production and
consumption).

  Actually,

financial cycles tend to repeat more often than business
cycles.

=> It makes it difficult to consider them as predictive
      signals
to anticipate economic evolutions.

We can see cycles in many social fields , for example in
"public choice" (see that phrase), or in garment fashions.

A well-known one in politics is the "majority cycle" (the "voter's
pendulum").

Cyclical analysis / cycle-trend analysis

Avoiding misinterpretations
that might make you red-faced
and might shrink your purse.

However irregular cycles are, they have to be detected and taken into
account in order to separate short term economic fluctuations from long
term evolutions
.

It is thus necessary to use long enough time series when analyzing economic
growth for example so that not to be misled by the "law of small numbers" (see
that phrase).

Cycle-trend have also to be accounted for to assess stock market levels.

The level of P/Es (Price-earnings ratios) might be misleading
because of "earnings cycles"
.

A high P/E might mean two different things:

Either the stock is overpriced,

Or earnings are momentarily very low because the company (or the
  
sector, or the whole economy) is in the low point of its business cycle.

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This page last update: 22/08/15
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