The stock markets, also known as the stock market, and the economy follow swinging paths on a chart. The rollercoaster rise and fall of the chart occur at different times depending on investor sentiment and confidence, geopolitical and government influences, and consumer purchasing power and outlook.
Knowing the relationship between the stock market and the economy can help you develop strategies for investing in mutual funds.
Cycle definitions
Mutual funds are investment groups based on shares and other investment instruments. They are created from shares of public companies, which are traded on platforms where shares 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 its price at the close of the market.
The economy is much more complicated to measure. The Federal Reserve generally uses the Consumer Price Index (CPI) to indicate the strength of the economy, but there are many other measures used to measure the financial performance of businesses and consumers. The strength of the economy fluctuates for various reasons and also tends to follow cycles.
The CPI measures the average change in prices paid overtime by consumers for a defined group of goods and services.
Stock Market Performance
Investors track the prices of stocks on the exchanges where they are bought and sold daily, weekly, monthly, and annually. Savvy institutional investors have selected stocks that have performed to their standards over time and created lists of stocks that they follow.
These indices are the most publicized and are commonly referred to when discussing the stock market. The Dow Jones Industrial Average and Standard and Poor’s 500 indices are the two most popular indices.
Stock prices fluctuate for many different reasons. When prices are trending up and the data indicates that prices will continue to rise, investors refer to the stock market as a bull market.
A bull market reflects rising prices because a bull slams its horns upwards. A bear slithers down with its claws, so a bear market reflects falling prices.
If prices are generally falling and are expected to continue to fall, investors call the stock market a bear market.
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 commerce. Economies are tracked by the selling power of businesses, 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 flow rate of inflation and growth, the economy is expanding and healthy. Specific circumstances cause unemployment to rise, the production of goods and services to decrease, and consumers to reduce their spending. Growth slows and may even turn negative or shrink.
Contrary to common belief, some inflation is good for the economy. Slow inflation is thought 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 a graph going up when the data is plotted. When it’s not, it’s contracting, seen as the downward slope of the chart. This is also called a recession.
The relationship
Investors love an expanding economy. Consumers are spending more, starting more new businesses, profits are soaring, and investment returns tend to rise. Investor sentiment, their view of the economy, and how stock prices will react is positive, building confidence in the economy; a bull market forms and the economy begins to expand.
When investors’ confidence in the economy begins to falter, stock prices begin to fall as investors begin to sell to avoid losing money. Stocks become less attractive as investors turn to other methods of generating returns. The economy loses momentum, growth slows, and a bear market emerges.
Economic momentum is the continued growth trend of an economy based on positive investor sentiment and confidence and consumer spending, providing a suitable environment for business growth. Momentum diminishes when consumer spending and business investment are reduced.
Investors can regain their confidence and boost confidence, sparking a rally that can lift the market and economy out of a declining growth rate and back up again. Sometimes investors fail to spark a rally and stock prices continue to fall. Economic growth continues to contract, profits decline, people are laid off from work, and consumer spending shrinks.
Investors provide financing for businesses, and businesses provide income to consumers. Consumers spend, creating demand for products and services. Companies grow to meet rising demand until the next influential event causes confidence to drop and sentiments turn negative. Prices peak, then start to fall, and both cycles repeat.
Officials only declare a recession or boom months after stock indices start losing or gaining points. This is done to ensure that the economy and stock market do not rise and fall in small increments as usual, but expand or contract.
Timing strategies with the stock market and business cycles
Some investors use indicators and past cycles to try and time stock price fluctuations. The timing of market fluctuations is guesswork at best, but you can keep an eye out for specific indicators to help you know when to start moving between asset classes.
When economists announce a recession, the Federal Reserve (the Fed) implements monetary policies that lower interest rates. This encourages consumer spending and drives up the price of bonds, which is a type of investment many people turn to when the economy starts to slow down.
In contrast, the Fed raises interest rates when a recession is declared over. Bond prices begin to fall and stock prices begin to rise. Many investors convert from bonds to stocks at this time.
This strategy allows investors to make profits rather than lose money when recessions hit. It does not guarantee that you will not lose money when the market changes, but it is a strategy in use.
The early stages of economic recovery may be the best time to invest in small caps and value stocks because they are often best positioned to bounce back from tough economic times. During the latter stages of the business cycle, growth stocks typically do well. This is part of the premise behind momentum investing.
The relationship between the stock market and the economy cannot be simplified into a single article. Many external factors, emotions, and conditions cause the stock market to crash and the economy to crash, or soar and grow.
There is no magic bell or 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 on to it no matter what) is one of the most preferred. Combined with dollar-cost averaging, a long-term strategy to continue investing a regular amount of money regardless of market conditions, the two strategies are generally very sound.
If you want to use the elements of buying and holding combined with market timing, you might 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 the peaks and troughs of the stock market and the economy. Attempting to time the market increases investment risk. Consider that timing the market, rather than timing the market, is the best investment strategy for most investors.
