Introduction to Cyclical Investing
"The fact that the cyclical game is a game of anticipation makes it twice as hard to make money in this basket. The principal danger is that you hop too early, then get discouraged and sell. It's perilous to invest in a cyclical stock without having a working knowledge of the industry "
- Peter Lynch, author of the best-selling book One up on Wall Street
Cycles are nothing new to human life. The first allusion to economic cycles goes way beyond the history of Fiat Money or Stock Markets. It was on the battlefield of Kurukshetra, Lord Krishna introduced mankind to the Eternal Cycle of Samsara- life, death, and rebirth.
No, this module does not contain any more mythological references and from here on we'll be discussing Cyclicals straight-up. Market pundits assume the tulipmania crisis (circa early to mid-1600s) in erstwhile Holland to be the earliest specimen of a market bubble.
Let's dig a little deeper into this topic to understand the nuances of market cycles:
Back in the early 17th century, Tulips were considered a status symbol for Netherlands' rapidly growing affluent class. A man without a collection of tulips was disregarded and considered to be poor in taste. There was a rage and the prices of tulips started climbing gradually.
Soon, Flower peddlers were faced with a new problem. The demand for tulip bulbs far exceeded its supply. Other neighboring countries were also a part of this frenzy and the bubble reached its peak by 1634. Prices soared and reached unprecedented levels. It is said that the most expensive of tulips cost as much as a posh villa in Ireland. The tulips as such did not have any inherent value. Yet, more and more people joined the trade based on the simple notion that someone else would be willing to pay a higher price for the same set of tulips. In essence, they believed that prices could only go up (The Greater Fool Theory)
Simple, isn't it?
Most of the trades were highly leveraged using derivative contracts which exacerbated speculation. And just how every bubble is bound to get burst, this too met its fate when one of the market participants defaulted on their contracts at a public auction. Panic spread and prices started to fall. Many were forced to liquidate their positions and declared bankruptcy.
Although there has been widespread debate about the extent of the tulip crisis, the basic recipe for disaster is the same in almost all cases. The Dot-com bubble, Great Financial Crisis of 2007-08, and maybe even Bitcoin in the near future.
" Is bitcoin really tulipmania 2.0? " is a topic of discussion for some other day. For now, the key lesson to draw home is that when euphoria sets in, it's always wise to take some money off the table. But how do we know when euphoria will set in?
To answer this question- we will have to understand the different stages of a market cycle that we will learn in the next section.