The economic cycle of the herd

Alchemy has been around for centuries. It is based on the notion of being able to convert base metals into gold. For centuries, man has pursued this idea with a view to benefiting or making money from this mystical art form – with little success.

Market cycles and technical instruments to some extent follow a similar purist idea that one instrument, or collection of instruments, could potentially be created to accurately forecast the future direction of the markets, resulting in endless riches for the owner of this intellectual property.

What we know is that over time, the market does provide a wonderful, rich history of learnings and teachings, and when applied, these can be helpful. One example is when similar events take place, such as the 1918 Spanish Flu pandemic, compared to the COVID-19 pandemic just a little over a century later.

We see whispers of history repeating itself with varying degrees of accuracy, but like water, history’s liquid nature makes any firm footing difficult as a sense of reliability to make accurate calls on the markets. The resemblance of the 1908 banking panic compared to the 2007 GFC almost 100 years later was just not exact enough to use for widespread timing points or any scientific scrutiny of academic standing.

This makes the cycle-work and technical indicators part-art form, part-data science, part-probability analysis concoction. The reality of being exact in nature is a fluid idea compared to scientific precision of academic analysis.

The problem of technical indicators becomes exacerbated with the backdrop of high-frequency traders; algorithm traders spend millions on data scientists and programmers. They have already programmed in stop losses of 10%, 20%, and other round numbers, Fibonacci retracements, resistant and support lines – yep, they are also likely to be in there too. Today, they just playfully twist these indicators with large sums of money to potentially profit from them, taking the opposite viewpoint of what investors might do. One only has to take a skip across the Pond to look at the crypto market to see this in its extreme form; the US Justice Department has been investigating this area of the market for some time.

The question of not so much whether the rhythms of history should be discarded entirely, rather it’s a case of buyer beware coupled with a fair amount of common sense, logical thinking, and some expertise.

The notion of an ‘economic clock’ is one that has popped up through history as the idea of an exact instrument that helps investors to understand the cycles of the market. The US National Bureau of Economic Research cited that since 1854 there have been 33 business cycles, which follows a typical boom-bust scenario.

The accuracy of these changes in the market environment are not quite as exact as a Swiss watch. Take the inverted yield curve, which has historically been a bellwether indicator as a precursor to a recession since 1970, puzzles academics. Will its winning streak continue, or will it be twisted by some algo trading team in future years? A paper by Jonathan H. Wright, conducted by the Federal Reserve struggled to explain using scientific reasoning why they occur and like crop circles, it’s a puzzle that has perplexed academics for decades.

Historically the focus on the economic clock has often been on smart money or sophisticated investors, with less focus on the ‘herd’ or the mum-and-dad investor psyche.

An interesting trend we have observed has been the recurrence of ‘the economic clock of the herd’. The notion that less sophisticated investor/s follow a well-trodden goat track through the boom–bust business cycle is an interesting one to explore.

The idea is that during times of panic, the herd will rush to cash/fixed interest and gold, then as things start to improve, the economic landscape often has lower interest rates and banks are encouraged to start lending to stimulate the economy. Being hurt by the downturn, these investors will move towards hard assets such as property. As the economy starts to get into the later stages, they will start to pivot towards the high returns of shares, only to repeat the process over and over with varying degrees of success.

It is an interesting concept and, like the market signposts, with the whispers of time it will be interesting to see if this cycle holds some resemblance. Keep in mind, though, that like any stampede, the herd’s pattern is not where the smart money is headed – they’re off to greener pastures and this may explain the divergence of wealth creation. But it’s a puzzle we have not unpacked to date.

I would not recommend you try using technical indicators or market-cycle instruments due to their unreliability and not having any academic standing. It is important you seek professional guidance from a practising and suitably qualified financial planner that meets FASEA education obligations, such as AJ Financial Planning.