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Market Cycles

What goes up, must come down? Well, not necessarily. Stock markets rise and fall in value in a pattern, called a market cycle. The overall market prices go up for part of the cycle and then, they tend to go back down. The big unknown is how long any phase of a cycle will last or when the next phase will begin.

Stock market prices, just like any other prices, are mostly a matter of supply and demand. The stock market goes up when there's a lot of demand and when most investors are buying stocks. And the market falls when there's supply created and investors are selling.

Other factors influence the way investors act, based on their feelings about whether they'll make or lose money by owning stocks. Most of the time, what's happening in the economy makes the greatest impact. When corporate earnings are strong, unemployment is falling, and interest rates are low, indexes tracking stock prices tend to rise. When the opposite happens - disappointing earnings, high unemployment, and rising interest rates - investor confidence wanes, and the indexes do, too.

And though it's not quite as dramatic, domestic political wrangling, international instability, and even severe weather conditions can influence investor behavior as well.

Moving with the cycles

Recognizing the bottom of a falling market or the top of a booming one is nearly impossible before the market has clearly moved on to its next phase. But if you buy and hold stocks in a variety of robust companies as well as some undervalued ones that are poised to grow, you may be well-positioned to profit from the companies' successes, weather a downturn without major losses, and benefit from the next growth phase. You might even want to buy more shares in the downturns if you have the patience to wait for the rebound (but of course, there's no guarantee that there will be a rebound).

One signal that the market might be gaining ground is that certain companies start to raise prices as demand for their products and services grows. The extra income often means larger profits for the company, and the potential for bigger dividends and higher stock prices for investors. That encourages even more investment.

On the downside, it's difficult to predict how low prices might go, and which companies may not survive or even make a rebound. No economic cycle is exactly like an earlier one. A new downturn may put different pressures on a company than it has experienced before. During a market drop, it may be a good idea to assess the business fundamentals of any company whose stock you hold to figure out if it is still a good investment. What you're trying to decide is if you should hang on to what you own, buy more shares when the price is low, or sell to cut your losses.

Bulls and Bears

When stocks gain value and their benchmark indexes reach new highs, it's called a bull market. Then, when the stock market falls 20% or more from its most recent high, you're in bear market territory. A more modest drop, in the 10% range, is known as a correction. The time period in which that happens varies.

While the past doesn't guarantee the future, it has been true, overall, that bull markets have lasted longer than the bear markets that bookended them. But market drops tend to happen more quickly than market gains. Think of it this way: it takes a lot longer to push or pull something heavy up 1,000 feet than it takes the object to fall that distance.

Opposites Attract

Different asset classes are usually on different market cycles, which means they produce their strongest returns at different times. That's because the different classes are affected differently by what's happening. Stocks, for example, often provide disappointing returns when interest rates rise because investors think they will make more money with fixed-income investments, including bond funds, and even insured bank products, such as CDs. But the fixed income products tend to thrive on high rates. Although they are paying investors and depositors more interest, they are also charging higher rates on their loans.

Let's talk correlation. Correlation is a measure (on a scale of 1 to -1) of how similarly or differently two asset classes tend to behave as the economy changes. If two classes react the same way, gaining and losing value at the same time, they have a positive correlation of 1. Those that tend to move in opposite directions most of the time have a negative correlation of -1. For example, bond funds and CDs tend to be positively correlated, while bond funds and stock funds tend to be negatively correlated. However, in some difficult economic periods, such as the recession that began in 2007, all asset classes can lose value at the same time.

An asset allocation strategy that stresses the importance of owning both positively and negatively correlated assets may help provide a defense against cyclical downturns in asset class performance. But there is a caution: Asset allocation doesn't guarantee a profit or protect against downturns.