Stock Market and Economic Cycles
How the Stock Market and Economic Cycles are Related
Understanding the difference between stock market and economic cycles and how they are related to investment performance can help determine the best timing strategies and portfolio structure.
For example, did you know that a bull market for stocks typically peaks before the economy peaks? In different words, a new bear market for stocks can begin even as the economy continues to grow. In fact, by the time the Federal Reserve officially announces a recession has begun, it could be a good time to get more aggressive and start putting more of your investment dollars back into stocks.
This article explains why the stock market and economy peak and trough at different times and how you might structure a portfolio to maximize returns. However, keep in mind that time in the market, as opposed to timing the market, is the best investment strategy for most investors.
Defining and Differentiating 'the Market' and 'the Economy'
All investors, which includes individuals, asset managers, pension funds, banks, insurance companies, just to name a few, collectively make up and influence what most refer to as "the market." Technically, the market refers to capital markets, which is a marketplace for investors to buy and sell investment securities, such as stocks, bonds and mutual funds.
When you hear or read about a reference to "the economy" it most often refers to what makes up an economic system, which includes consumers, industry, corporations, financial institutions and government.
In simple terms, the economy is a reference to the overall financial environment, most often that of the United States (US economy) unless specifically referenced as "the global economy," which would include all countries in the world.
The Stock Market Looks Forward, the Economy Looks Back
Now, with the formalities out of the way, think of what investors are doing that influence the market: They are studying all available information about current conditions, including economic, but primarily the financial health of corporations and the individual (consumer).
Investors are also looking forward and estimating prices for stocks today based upon reasonable expectations about the future, say 3 to 6 months ahead. This is why the stock market has been called a "forward looking mechanism" or "discounting mechanism." If something unexpected comes along, either positive or negative, stock prices will react (or be "discounted") accordingly. This is also a basic premise of the Efficient Market Hypothesis (EMH).
In contrast to the market and investors, the economy, or more accurate to say, economists, look backward. They are looking at historical data, usually one to three months back, to provide measurements of economic health. For example, if an economic recession began today, it would not be reported by economists with certainty for at least one month (or even three months or more if you factor in their revisions).
Now consider that the average duration (length) of a bear market for stocks is one year. By the time economists herald the news that a recession has begun, the bear market may have already been in place for three or four months, and if it's below average in duration, it may be time to start buying back into stocks.
Similarly, once economists announce the recession has ended and a new period of economic growth has begun, a bull market for stocks may already be months old.
This is why the stock market has been called a "leading economic indicator" because it can (but not always) predict the near-term future direction for the economy.
Timing Strategies With Stock Market and Economic Cycles
Now that you know how the stock market and economic cycles relate in time (market leads by approximately three months) you can begin thinking of strategies that can work at certain times. For example, when economists have announced a recession has begun, you can expect the Federal Reserve to begin policies to push interest rates down, which will push prices for bonds higher. You may want to increase exposure to bonds at this time. In contrast, you may decide to decrease exposure to bonds when economists have declared recession has ended because bond prices will fall once interest rates begin rising again.
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 late stages of the economic cycle, growth stocks often do well. This is part of the premise behind momentum investing.
Challenges and Cautions With Market Timing
Although the relation between the stock market and the economy can be simplified within a thousand-word article, market timing can be incredibly complex and therefore foolish for most investors to attempt. There is no magical bell that is rung when it is time to get in or out of stocks. For most investors the buy and hold strategy works well, especially when combined with dollar-cost averaging.
If you want to use the best elements of buy-and-hold combined with market timing, you may consider something called tactical asset allocation, which can produce better results if applied correctly.
In summary, all investing incorporates some degree of market timing. The best approach for most investors wishing to maximize returns and minimize risk is to build the best portfolio of mutual funds for their own objectives and risk tolerance.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.