Economics is a measure of all economic activities, while stock markets are a measure of the financial health of public companies. Although the two are interconnected and often distorted, they are different and are subject to different cycles of growth and decline. Economic factors affect corporate profits and, consequently, stock market returns.
What are Economic and Market Cycles?
Economic cycles and stock market cycles are a means of understanding the pattern of growth and decline in the economy and stock markets, respectively. They are caused by various but related factors.
Note: Economic cycles can last from 28 months to over 10 years, whereas stock market cycles are shorter, averaging between 6-12 months.
Economic Cycles
Economics refers to the economic system of the country. Economic cycles represent alternating periods of growth and decline in economic activity.
When business is booming, people are employed and spending, the economy expands and is healthy. There is often a low investment and growth rate. Sometimes, unemployment may rise, production slows down, and people cut back on spending. Growth slows and can even turn negative or contract.
Important: Some inflation is considered good for the economy. Slow inflation is believed to prevent deflation and encourages people to spend instead of waiting for prices to fall.
Stock Market or Business Cycles
Stock and commodity prices rise and fall based on various conditions. This causes cycles in their prices. The performance of stocks is mostly measured by their prices at market close.
You can track stock prices on exchanges; this is where they are bought and sold daily, weekly, monthly, and annually. Experienced institutional investors have stocks that have led to their benchmarks over time. They often create lists of stocks they track.
These indices are the most promoted and discussed when talking about the stock market. The Dow Jones Industrial Average and the S&P 500 are the most famous indices.
Stock prices vary for different reasons. When prices trend upward, and data indicates they will continue to rise, the stock market is called a bull market.
Note: A bull market reflects rising prices because a bull thrusts upward with its horns. A bear swipes downward with its claws; a bear market reflects falling prices.
If stock prices fall more than 20% and are expected to continue declining, the stock market is referred to as a bear market.
Stock Market and the Economy
Investors favor a growing economy. As people’s spending increases, more new businesses open, profits rise, and investment returns typically increase. Investor sentiment and their perception of the economy and how stock prices react are positive. This builds confidence in the economy; a bull market forms, and the economy begins to expand.
When confidence in the economy starts to collapse, stock prices begin to fall. Investors start selling to avoid financial loss. Stocks become less appealing as people turn to other means for returns. The economy loses the momentum it had. Growth slows and remains so until the economy contracts.
Note: Economic momentum is when the economy grows based on positive confidence and consumer spending. This creates a strong environment for business growth. Momentum decreases when spending and investment in businesses decline.
Investors can regain confidence and boost sentiment; this can cause a rise that can pull the market away from a lower growth rate and make it increase again. In some cases, investors do not trigger price increases. Stock prices continue to decline. Economic growth continues to shrink, profits drop, people are laid off, and spending is curtailed.
Investors provide funding to businesses. Businesses provide income to consumers. Consumers spend, creating demand for goods and services. Companies grow to meet increasing demand until the next major event causes confidence to drop. Prices reach a peak, then begin to decline, and the two cycles repeat.
Important:
Officials declare a recession or expansion months after stock market indicators begin to lose or gain points. This is done to ensure that the economy and stock market are not rising and falling by small increments as usual, but are actually expanding or contracting.
Investment Strategies for Economic and Stock Market Cycles
Although market fluctuations are said to balance out in the long run, you can use some investment strategies to ensure you maximize your benefits from those fluctuations to add to your savings.
Use Historical Data and Economic Indicators
While it’s never a good idea to time the stock market, some investors use indicators and past cycles to try to guide their investment decisions. Timing market fluctuations is a guess at best. However, you can monitor specific indicators to help you know when to start moving between asset types.
When economists announce a recession, the central bank (the Federal Reserve) implements monetary policies that lower interest rates. This encourages consumer spending and boosts bond prices. Bonds are a type of investment that many turn to when the economy begins to contract.
On the other hand, the central bank raises interest rates when the end of the recession is announced. Bond prices start to decline, and stock prices begin to rise. Many switch from bonds to stocks at this time.
This strategy allows investors to achieve returns instead of losing money when recessions hit. It doesn’t guarantee that you won’t lose money when the market changes, but it is a strategy used.
Tip: The early stages of economic recovery can be the best time to invest in small-cap and value stocks; they are often in the best position to recover from tough times. During the later stages of the economic cycle, growth stocks are often good. This is part of the momentum investing hypothesis.
Buy-and-Hold Strategy
There is no magic indicator that tells people when it’s time to buy or sell stocks. For most people, the buy-and-hold strategy is one of the best strategies. This method involves buying a stock and holding onto it, regardless of what happens.
Many try to restructure their portfolios based on stock market peaks and troughs and the economy. Trying to time the market means more risk in investing. In most cases, time in the market beats timing the market. This makes it one of the best strategies for most people.
Dollar-Cost Averaging
The buy-and-hold strategy is sometimes combined with the dollar-cost averaging strategy. This is a long-term strategy that invests a fixed amount of money regularly, regardless of market conditions. If markets decline, the average cost of your investment also decreases, making any future rise more profitable.
Tactical Asset Allocation
Tactical asset allocation is a strategy that adjusts your portfolio based on market conditions. For example, let’s say your portfolio consists of 60% stocks and 40% bonds. If stock markets rise, the value of the stock portion in your portfolio may increase. More weight on stocks means higher risk, so you might sell some stocks to bring the weighting back to 60%.
Frequently Asked Questions (FAQs)
How does the stock market affect the economy?
The performance of the stock market can reflect economic conditions. Stock markets rise when investor confidence is high, and investors are buying stocks. Stock markets fall when investors lose that confidence and pull their money out.
Why is the stock market not the economy?
The stock market consists only of the companies and financial products listed on that particular exchange. The economy includes all economic activities, including private companies and investment transactions that do not occur on the stock market.
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Sources:
– Fidelity Investments. “Markets, emotions, and you.”
– RBC Asset Management. “Understanding the Economic and Stock Market Cycles.”
– Federal Reserve Bank of San Francisco. “What is the Fed: Monetary Policy.”
Source: https://www.thebalancemoney.com/stock-market-and-economic-cycles-2466840
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