The economy measures all economic activity, and stock markets gauge the country’s company’s financial health. Though related, they differ in cycles of growth and decline. Economic factors affect corporate profits and, consequently, stock market returns. But how exactly do these affect your investment decisions, especially the long-term stocks? Let’s understand with the basics.
What is an economic cycle?
The economy is the system of a country, and economic cycles are the periods of fluctuations that define growth and decline in economic activity. These cycles include four phases: expansion, peak, contraction, and trough.
- Expansion:
Expansion is when the economy proliferates with low interest rates, higher production levels, and moderate inflation. There is a constant demand for goods and services, leading to higher production and employment. People buy more because there’s a steady supply of money. This phase also attracts fresh corporate and infrastructure investments, boosting GDP growth.
- Peak:
After sustained expansion, the economy reaches a ‘peak’ where growth slows down. Indicators show signs of slowing production rate, and fresh investments become scarce, causing stock markets to cool. Prices reach their highest, making it hard for consumers to buy luxury goods.
- Contraction:
Following the peak, the economy enters the ‘Contraction’ stage. High prices reduce the demand for goods and services, leading to a high-supply and low-demand scenario. Unsold goods pile up, forcing manufacturers to slow production. This results in layoffs and higher unemployment. GDP growth decreases, causing widespread economic gloom.
- Trough:
The trough follows a prolonged contraction phase. The economy hits its lowest point, and the demand and supply of goods are minimal. Consumers conserve money for essential needs, avoiding fresh purchases.
After hitting a low point, the economy starts to show signs of recovery catalyzed by government spending and new corporate investments. People with extra money get excited by the low prices of goods and services and start buying. This creates new demand in the economy, which slowly increases the production. New jobs are created, and eventually, the economy enters the expansion phase again.
Stock market movement during the economic cycle:
The stock markets react to the changes in the economic cycles. Let’s understand how.
- Stock Market Rise During Expansion:
When the economy grows, businesses often see higher profits and revenues. This good performance makes investors willing to pay more for stocks, causing stock prices to rise. For example, during the tech boom in the late 1990s in the U.S., the economy expanded, leading to a significant increase in technology stocks. Similarly, in India, during the mid-2010s, economic expansion led to a surge in IT sector stocks.
- Stock Market Fall During Recession:
On the contrary, businesses might report lower profits or even losses during a recession. This makes investors less willing to pay high prices for stocks, causing stock prices to fall. One known example is the 2019 economic slowdown in India when the stock prices declined, especially in sectors like auto and real estate.
- Cyclical Sectors and Economic Cycle:
Certain sectors, called cyclical sectors, move in line with the economy. The automobile industry is a good example. When the economy is strong, and consumers are spending, auto sector stock values rise. When the economy weakens, their values fall. The real estate sector in India often mirrors these economic ups and downs.
While the stock market and the economy usually move in the same direction, they can behave quite differently, especially in the short term. This is because the stock market looks ahead, while some economic data reflects past events.
How do you invest as per the economic cycle?
- Use Historical Data and Economic Indicators
While timing the stock market is risky, you can use indicators and past cycles to guide your decisions. Watching specific economic indicators can help you decide when to shift between asset types. For instance,
- When a recession is announced, the government usually lowers interest rates to encourage consumer spending, which boosts bond prices. So, you can turn to bonds during economic downturns.
- When a recession ends, interest rates rise, bond prices fall, and stock prices climb. This is when you can shift to stocks.
- In early economic recovery stages, small-cap and value stocks often rebound well. Growth stocks tend to perform better during late economic cycles, supporting momentum investing.
These strategies aim to minimize losses during recessions, though it’s not foolproof.
- The Buy and Hold Strategy:
The buy-and-hold focuses on buying and holding onto a stock regardless of market fluctuations. Trying to time the market usually increases investment risk. So, staying invested in the market proves more beneficial than trying to predict its movements.
- Rupee-Cost Averaging:
This strategy is often paired with buy and hold. Rupee-cost averaging means investing a fixed amount regularly, regardless of market conditions. When the market drops, the average cost of your investments decreases, making future gains more profitable.
- Tactical Asset Allocation:
In tactical asset allocation, you actively rebalance your portfolio based on market conditions. For example, if your portfolio is 50% equities and 50% bonds and stock markets rise, the equity portion’s value increases. At this point, you must sell some stocks to manage risk and maintain a 50% equity balance.
Conclusion:
The Indian economy is currently in the early recovery phase, and the stock market is stabilizing and growing eventually. By understanding the correlation between the economic cycle and the securities market, you can adjust your portfolio and make better investment decisions for the long term. However, it is advised that you consult a SEBI-registered investment advisory for a thorough analysis of the economic cycle for your investment decisions.
FAQs:
- How is the economy affected by the stock market?
The stock market can reflect economic conditions. When the market rises, it shows high investor confidence and increased stock buying, indicating strong economic activity. Conversely, when the market falls, it signals lost confidence, leading to investors pulling their funds out.
- What is an all-weather portfolio?
As a long-term investor, you’ll face different economic and market conditions. It’s wise to build portfolios that endure downturns and profit when markets rise. These are known as ‘all-weather’ portfolios.