Stock markets boom during economic expansion and fall during economic contractions. Most investors cannot time stock market cycles but they can use strategies such as buying and holding, dollar-cost averaging and tactical allocation to make the most of them.
What Are Economic and Market Cycles?
Economic cycles and stock market cycles are a way to understand the pattern of growth and declines in the economy and the stock markets, respectively. Different, but related, factors cause cycles in the economy and the stock markets.
Economic Cycles
The economy refers to the economic system of a country. Economic cycles represent the alternating periods of growth and decline in economic activity. When business is booming, and people are working and spending, an economy is expanding and healthy. There is often a constant low rate of inflation and growth. Other times, unemployment may rise, production slows, and people reduce their spending. Growth slows, and can even become negative, or shrink. When the economy is booming and growing, it is in a state of expansion. This is seen by the upward climb of a graph when data is charted. When it is not, it is contracting. This is seen as the downward slope of the graph. It’s also called a recession.
Stock Market or Business Cycles
Stock and commodity prices rise and fall based on various circumstances. This causes cycles in their prices. Stock performance is most often measured by its price at market closing time. You can track stock prices on the exchanges; this is where they are bought and sold daily, weekly, monthly, and annually. Experienced institutional investors have hand-picked stocks that have performed to their standards over time. They often create stock lists that they track. These indexes are the most publicized and are commonly referred to when discussing the stock market. The Dow Jones Industrial Average and the Standard and Poor’s 500 are the two most popular indexes. Stock prices vary for many different reasons. When prices follow a rising trend, and data indicates prices will keep rising, the stock market is called a bull market. If stock prices fall more than 20% and expected to keep falling, the stock market is called a bear market.
The Stock Market and the Economy
Investors love an expanding economy. As people spend more, more new businesses open, profits soar, and investment returns tend to go up. Investor sentiment, their view of the economy and how stock prices will react, is positive. This creates confidence in the economy; a bull market forms, and the economy begins to expand. When confidence in the economy begins to fail, stock prices start falling. Investors begin selling to avoid losing money. Stocks become less attractive as people turn to other methods of getting returns. The economy loses the momentum it had. Growth slows, and a bear market emerges. Investors can recover their confidence and boost sentiment; this can cause a rally that can pull the market out of a lower growth rate and cause it to increase again. In some cases, investors don’t cause a rally. Stock prices keep dropping. Economic growth continues to contract, profits decline, people are laid off from work, and spending reduces. Investors provide funding for businesses. Businesses offer income for consumers. Consumers spend, creating demand for products and services. Businesses grow to meet higher demand until the next big event causes confidence to drop. Prices peak, then begin to fall, and both cycles repeat.
Investment Strategies For Economic and Stock Market Cycles
While ups and downs in the markets are said to even out over the long-term, you can use some investing strategies to ensure you’re making the most of those fluctuations to add to your nest egg.
Use Historical Data and Economic Indicators
While its never a good idea to time the stock markets, some investors use indicators and past cycles to try to inform their investment decisions. Timing market fluctuations is guesswork at best. But you can watch for specific indicators to help you know when to begin moving between asset types. When economists announce a recession, the Federal Reserve (the Fed) implements monetary policies that push interest rates down. This encourages consumer spending and boosts the price of bonds. Bonds are one investment type many people turn to when the economy begins to recede. On the other hand, the Fed raises interest rates when a recession is declared over. Bond prices begin to fall, and stock prices start climbing. Many people convert from bonds to stocks at this time. This strategy allows investors to receive returns rather than lose money when recessions hit. It isn’t guaranteed to keep you from losing money when the market changes, but it is a strategy in use. The relationship between the stock market and the economy can’t be simplified into one article. Many external factors, emotions, and conditions cause the stock market to crash and the economy to collapse—or soar and grow.
The Buy and Hold Strategy
There is no magic indicator that lets people know that it is time to buy or sell stocks. For most, the buy and hold strategy is one of the best. This method consists of buying a stock and holding it, no matter what happens. Many people try to restructure their portfolios based on the peaks and troughs of the stock market and economy. Trying to time the market means more investment risk. 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 dollar-cost averaging. This is a long-term strategy in which you invest a regular amount of money, no matter what the market looks like. If the market goes down, then the average cost of your investment also goes down, making any future upside more profitable.
Tactical Asset Allocation
Tactical asset allocation is a strategy where you actively rebalance your portfolio based on market conditions. For example, let’s say your portfolio is composed of 60% equities and 40% bonds. If the stock markets rise, then the value of the equity portion of your portfolio may go up. More weight to equities means higher risk, so you could sell some of your stocks to bring that weight back down to 60%.
