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 market and the economy both follow oscillating paths on a graph. The chart's rise and fall occur at different times. This is based on investor sentiments, geopolitical and government influences, and consumer purchasing power and outlook.

Learn more about the relationship between the stock market and the economy. This can help you develop strategies for mutual fund investing.

Cycle Definitions

Mutual funds are investment pools based on stocks and other 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. This causes cycles in their prices. Stock performance is most often measured by its price at market closing time.

The economy is much more complicated to measure. The Federal Reserve (the Fed) most often uses the Consumer Price Index (CPI) to express the economy's strength. But there are many other measurements used to gauge financial performance. The strength of the economy fluctuates for several reasons; it also tends to follow cycles.

Important

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

Stock Market Performance

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.

Note

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

If prices are mostly falling and expected to keep falling, the stock market is called a bear market.

What Is the Economy?

The economy refers to the economic system of a country. The system most often includes consumers, industry, corporations, financial institutions, small businesses, government, commerce, and trade. Economies are tracked by businesses' selling power; they're also tracked by purchasing power and the rate of supply and demand.

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.

Important

Some inflation is good for an economy. Slow inflation is believed to prevent deflation and keep people spending rather than waiting for lower prices.

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.

The Stock Market and the Economy

Investors love an expanding economy. 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.

Note

Economic momentum when an economy grows based on positive sentiment and consumer spending. This provides a strong environment for business growth. Momentum declines when spending and business investment are reduced.

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.

Important

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. 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.

Tip

The early stages of economic recovery can be the best time to invest in small-cap stocks and value stocks; they are often best-positioned to bounce back from 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 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.

It's often 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. Together, the two strategies are often very sound.

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

Many people try to restructure their portfolios based on 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.