Market Cycles and Feedback Loops
Do you ever feel like you’re too close to something?
Sometimes, you can be so close to what’s happening, that you can be hard-pressed to feel (or see) anything other than the chaos.
Yes, “this or that” trend may have a nice-sounding narrative, and it may even appear to be the greatest thing since sliced bread, but, sometimes, if you’re just able to take a few steps back, you may more easily see all that glitters isn’t gold.
With the New Year almost a month over, and with volatility still fresh in our minds, we thought it would be helpful to take a few steps back and see if we can’t get a better look at the long-term market environment.
Year-after-year, whether it’s the change of seasons from winter to spring, or the change of a caterpillar into a butterfly, it’s hard to deny that cycles are all around us.
Not all cycles are related to nature, however.
There are political cycles, technological cycles, debt cycles, business cycles, and economic cycles.
With the non-natural cycles, there are a plethora of experts and opinions about where we are and where we’re going. This is perhaps most obvious as it pertains to the markets, economy, and politics.
Many expert opinions don’t seem any more scientific or contain any more actual insight than the yearly weather prediction offered by the shadow of Punxsutawney Phil (the most famous groundhog of all!)
Still, however, we need to pay attention.
What we do know is that we will have good times and bad times. We will have short winters, but also long ones. We will have economic expansions and contractions. We’ll have bull and bear markets.
With that in mind, so that we may have a better idea of what factors impact the markets, let’s look at some of the less obvious reasons that various cycles occur.
While we know that cycles are inevitable, feedback loops are not.
Feedback loops can coincide with (or even lead) a cycle. They can be isolated to one small area (i.e. Bitcoin) or they can be systemic (i.e. the crash of ’87).
A feedback loop (outside of the scientific definition) is something that gets input or feedback from itself, and subsequently impacts itself. For example, a falling market creates volatility which then causes more selling, which, in turn, begets more volatility.
A feedback loop could also occur when asset prices rise.
A certain number of buyers help push an asset price higher. More people take notice and don’t want to miss the upswing. They jump in and the asset price moves even higher. After a while, it seems everyone knows about this secret, hot investment, and the price continues going up.
Bitcoin was an excellent example of this: a true bubble, feeding off itself in an upwardly spiraling (and later a downwardly spiraling) loop.
To be sure, not all feedback loops are amplifying. In fact, some are corrective and stabilizing.
The Federal Open Market Committee (FOMC) is meant to be a stabilizing feedback loop. When asset prices and employment and inflation are falling, the Fed will cut interest rates or engage in asset purchases (quantitative easing) to help stabilize the markets by encouraging risk-taking.
When inflation and the economy are running too hot and there are asset bubbles forming, the Fed will raise interest rates with the goal of deflating bubbles to discourage risk-taking.
Trade Wars and Government Shutdowns
This brings us to the current trade dispute with China and the government shutdown. These two issues are clearly not cyclical, but they can be seen as smaller feedback loops that feed into the larger cycle of the economy and markets.
The trade skirmish can be looked at through a couple of different lenses. It can be an amplifying loop with negative consequences: each side adding more tariffs and/or more restrictions with both economies getting hurt.
Now, looking through the other lens—though it’s counterintuitive—means one side is willing to inflict (or absorb) some short-term pain to level the playing field, making trade more fair and intellectual property rights more enforceable.
The first way of looking at it is going to exacerbate the problem while the second way of looking at it will stabilize or correct it (though it may be a longer-term endeavor).
What about the government shutdown?
Neither side acknowledges that they might be able to compromise. The longer the standoff continues, the more negative the potential impact, possibly costing everyone more than some sort of compromise would.
This brings us back to the Fed and where we are with rates.
If the economy is as fragile as the markets have portrayed it to be, the Fed needs to understand that markets are already self-correcting and little or no stabilization (e.g. rate hikes) may be necessary at this juncture.
Taken with the negatives of the trade skirmish and the government shutdown, the Fed correcting for an economy that is not overheating, and a market that is not rampant with asset bubbles, can all provide the market with more negative feedback and this can lead to more volatility.
We will be the first to tell you that modeling each of these out is extremely difficult. And since no one can model these things, we continue to emphasize diversification and the utilization of asset classes that we believe will contribute to lower total portfolio risk over the long term.
We may make new all-time highs in the market in 2019. We may also retest and break below the lows from Christmas Eve 2018. What we are confident of is that, eventually, like fall turning into winter, the cycle will come to an end and a new cycle will start.
One thing, however, is certain: If you’re not positive that your investments are diversified in a way that helps to protect your interests and long-term objectives, you should contact us today.
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January 22, 2019
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