How the Economic and Stock Market Cycles Are Related

What to Know About Market Cycles and Investment Timing Strategies

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The stock exchanges, also known as the stock market, and the economy both follow oscillating paths on a graph. The chart's roller coaster-like rise and fall occur at different times based on investor sentiments and confidence, geopolitical and government influences, and consumer purchasing power and outlook.

Learning the relationship between the stock market and the economy can help you develop strategies for mutual fund investing.

Cycle Definitions

Mutual funds are investment pools based on stocks and other investment instruments. They are created from public company stocks, which are traded on platforms where stocks and money are exchanged. These platforms are called exchanges.

Stock and commodity prices rise and fall based on various circumstances, causing cycles in their prices. Stock performance is generally measured by their price at market closing time.

The economy is much more complicated to measure. Generally, the Federal Reserve uses the Consumer Price Index (CPI) to indicate the economy's strength, but there are many other measurements used to gauge the financial performance of businesses and consumers. The strength of the economy fluctuates for several reasons and also tends to follow cycles.

The CPI measures the average change in prices paid over time by consumers for a defined group of goods and services.

Stock Market Performance

Investors track stock prices on the exchanges 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 and created 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 indexes are the two most popular indexes.

Stock prices fluctuate for many different reasons. When prices follow a rising trend, and the data indicate prices will continue to rise, investors refer to the stock market as a bull market.

A bull market reflects rising prices because a bull strikes upward with its horns. A bear swipes downward with its claws, so a bear market reflects falling prices.

If prices are generally falling and expected to continue falling, investors call the stock market a bear market.

What Is the Economy?

The economy refers to the economic system of a country. The system generally includes consumers, industry, corporations, financial institutions, small businesses, government, commerce, and trade. Economies are tracked by businesses' selling power, the purchasing power of consumers, and the rate of supply and demand for goods and services.

When business is booming, and people are working and spending—with a constant low rate of inflation and growth—an economy is expanding and healthy. Specific circumstances cause unemployment to rise, production of goods and services to decrease, and consumers reduce their spending. Growth slows, and can even become negative, or shrink.

Contrary to common belief, some inflation is good for an economy. Slow inflation is believed to prevent deflation and keep consumers spending rather than waiting for lower prices.

When the economy is booming and growing, it is in a state of expansion, indicated by the upward climb of a graph when data is charted. When it is not, it is contracting, seen as the downward slope of the graph. This is also called a recession.

The Relationship: The Stock Market and the Economy

Investors love an expanding economy. Consumers spend more, more new businesses start, profits soar, and investment returns tend to go up. Investor sentiment, their view of the economy and how stock prices will react, is positive, creating confidence in the economy; a bull market forms, and the economy begins to expand.

When investor confidence in the economy begins to fail, stock prices start falling because investors begin selling to avoid losing money. Stocks become less attractive as investors turn to other methods of creating returns. The economy loses the momentum it had, growth slows, and a bear market emerges.

Economic momentum is the tendency for the continuous growth of an economy based on positive investor sentiment and confidence and consumer spending, providing a suitable environment for business growth. Momentum declines when consumer spending and business investment are reduced.

Investors can recover their confidence and boost sentiment, causing a rally that can pull the market and economy out of a decreasing growth rate and cause it to increase again. Sometimes, investors don't cause a rally, and stock prices continue to decline. Economic growth continues to contract, profits decline, people are laid off from work, and consumer spending reduces.

Investors provide funding for businesses, and businesses offer income for consumers. Consumers spend, creating demand for products and services. Businesses grow to meet increasing demand until the next influential event causes confidence to decline and sentiments to become negative. Prices peak, then begin to fall, and both cycles repeat.

Officials only declare a recession or boom months after the stock market indexes begin losing or gaining points. This is done to ensure the economy and stock market are not rising and falling in small increments as usual, but actually expanding or contracting.

Investment Timing Strategies

Some investors use indicators and past cycles to try to time stock price fluctuations. 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, which is one investment type many people turn to when the economy begins to recede.

Conversely, the Fed raises interest rates when a recession is declared over. Bond prices begin to fall and stock prices start climbing. Many investors 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 early stages of economic recovery can be the best time to invest in small-cap stocks and value stocks because they are often best-positioned to bounce back from economic hard times. During the late stages of the economic cycle, growth stocks often do well. This is part of the premise behind momentum investing.

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 magical bell or any one indicator that notifies people that it is time to buy or sell stocks. For most investors, the buy and hold strategy (buying a stock and holding it no matter what happens) is one of the most preferred. Combined with dollar-cost averaging, a long-term strategy to continue investing a regular amount of money no matter what the market conditions are, the two strategies are generally very sound.

If you want to use the elements of buy and hold combined with market timing, you may consider something called tactical asset allocation, where you actively rebalance your portfolio based on market conditions.

Many investors try to restructure their portfolios based on peaks and troughs of the stock market and economy. Trying to time the market increases investment risk. Consider that time in the market, instead of timing the market, is the best investment strategy for most investors.