What Drives Stock Market Cycles?

Bull markets and bear markets are secular cycles. They are long-term -- often continuing for 10 years or longer. Inside the secular cycles are short-term reversals and sector rotation. At the beginning of a bull market, financials, technology and consumer goods outperform. In the middle of the bull market, raw materials, industrials, energy and telecommunications outperform. As the bull market ends and a bear market begins, health care, consumer staples and utilities are most successful, according to financial columnist Barry Ritholtz. These sector rotations give hints to what drives stock market cycles.

Inflation

When the economy is in recession, the Federal Reserve lowers interest rates and adds money to the financial system to spur business and consumer spending as a way to move the economy out of recession. Businesses and consumers borrow inexpensive money and spend it. Banks lend, businesses buy new technology and consumers buy goods. Spending has the effect of increasing corporate earnings. Stock prices generally rise based on good earnings. As the economy reaches its peak, companies manufacture more goods to sell to consumers, and borrowing reaches a peak. The money supply grows from all the consumer and business borrowing, and excessive growth in the money supply is inflationary. Cycles analysts watch the money supply for a hint regarding the end of a bull market cycle.

Federal Reserve

Controlling inflation is part of the Fed mandate, so it steps in to increase interest rates and remove money from the system. [ref 5] Higher interest rates discourage borrowing so business and consumer spending declines. Higher interest rates also increase business costs and, in combination with declining customer demand, result in lower earnings. Stock prices follow the direction of earnings, so stock prices decline. As Fed monetary policy dampens the economy, consumers spend money only on necessities such as utilities, medical care and essential goods. These sectors are considered defensive because their earnings remain relatively stable during a recession and so do their stock prices. Although there can be minor recessions during a bull market, the longer term secular cycles in the market tend to follow inflation and the response by the Federal Reserve.

Corporate Earnings

At the beginning of a bull market, low interest rates allow businesses to borrow inexpensively. A low cost of funding helps to increase earnings. In expectation of better earnings ahead, price/earnings ratios start to increase because the anticipation of good times ahead lures more investors into the market and the additional demand for stocks results in higher prices. Investors buy based on the expectation for higher earnings in the future, so as stock prices increase, earnings reflect only the most recent quarter. The price/earnings ratio increases because prices are moving higher faster than earnings. A bull market starts when the average P/E ratios move from low to high. When the Fed steps in to raise interest rates, investors expect lower earnings in future quarters, so the average P/E ratios decline. A bear market begins when P/E ratios move from high to low.

Political Influence

Changes in taxation influence market cycles. A reduction in taxes is thought to be a good sign for higher earnings, so the stock market generally responds with a rally. Higher taxes are thought to impede earnings growth, so P/E ratios decline as stock prices decline. Other Washington activities affect the markets, depending on the perception of how those actions will affect earnings and inflation.

Predicting Cycles

Analysts are constantly trying to predict the onset of a bear or bull market. In truth, this is a difficult thing to do because of the many variables involved. Charts show a clear picture after the transition from one cycle to another has taken place -- but during the transition, there is always the possibility that the market is undergoing a temporary correction in a much longer cycle.