GLOBAL financial markets, like weather patterns, are governed by macro and micro cycles and these cycles are definable and predictable. This may come as a surprise, but each financial asset class forms part of a larger constellation, much like a constellation of planets, and can be seen to move in a similar orbital way. All asset classes closely interweave with each other and are strongly influenced by each other in a similar way that planets are influenced by each other’s gravitational pull. The objective for the trader is to understand exactly “when” such movements are underway and “how” to capitalise on them. We can see these orbital movements of asset classes taking shape in the structure of business cycles.
Business cycles typically move from recession to recovery, to boom, to slowdown and to recession again. Normal business cycles from trough to peak and back to trough again usually last about seven years, unless there are unusual circumstances whereby commercial activity is skewed by strong external influences. Such influences would be things like the period of unusually abundant credit from 2003 to 2008, right up to the 2008 financial meltdown, which elongated the business cycle that started in 2000 by two years. Business cycles can be split into stages, each with defined patterns within them. As you can see from the table, stocks, bonds and commodities all perform differently during each stage.
ASSET CLASS MOVEMENTS
During each stage certain asset classes outperform each other depending largely on what interest rates and inflation are doing. The level of interest rates normally governs the behaviour of all asset classes, as the value, or cost of money, is directly related to the commercial activities of businesses and the prices of interest rate sensitive products, like bonds and currencies. If the trader can recognise the flow of the business cycle, he or she can then trade each asset class in relation to the other: for example, in stage five traders should short bonds and go long on commodities.
The power of understanding the cyclical nature of markets is that once you know what a single major asset class is doing you can work out what the other asset classes should be doing in relation to it. Markets are predictable in as much as we can understand which asset class is likely to outperform another when they come in and out of orbit. Business cycles can also form micro-cycles in an individual asset class.
Recognising which asset class is likely to outperform another can yield the trader exceptional profits. However, very few traders understand the extent to which cycles can influence markets and the flow of money from one asset class to another. Once they do, they are never lost for working out which asset class, sector or sub-sector should be moving.
David James Norman is a trader, CEO of the Trader Training Company and visiting professor at the Essex Business School, where he is running trader bootcamps in September and November 2011. Visit www.tradertraining.net and follow the link to Essex Business School, or contact Denise Sherer at firstname.lastname@example.org for information.