If you want to be a smart investor, you will have to know how the economy of a country impacts the stock markets of the country.
One of the key factors that has a direct impact on share prices is how the country is performing economically. If the economy is doing well and growing steadily, the stock markets will react positively, and the prices of shares will rise. On the other hand, if it is not, then the share prices will fall.
I think that you are already aware of this.
But did you know that every economy goes through various phases in a cyclical manner? Altogether, these phases are known as Economic Cycles. If you want to be an informed investor, then you need to know about these economic cycles and change your investment styles according to the phase that the economy is in.
What Are Economic Cycles?
The economy of every country in this world are driven by various factors like production of goods and services, employment levels, inflation, import export etc. Like everything in this world these factors also fluctuate from time to time depending on the demand and supply of goods and services in the economy.
When things are going well, there will be a positive sentiment in the market and the economy will be doing well. On the other hand, if things are not looking so positive then the economic that go into a downturn and the market sentiment will also turn negative.
Historically, it has been seen that these ups and downs in the economy come one after the other in phases. As already mentioned, these phases are called Economic Cycles.
What Are The Phases In An Economic Cycle?
There are 4 distinct phases in an economic cycle. These are:
- Expansion
- Peak
- Contraction
- Trough
Each of these phases can exist for a few months to a few years, and the whole economic cycle may often take as long as 4-10 years to complete.
So now let us understand these phases one by one.
1. Expansion
Expansion is the stage in which the economy grows rapidly and overall, the things look good. Typical indicators of this phase are low rates of interest, higher levels of production and moderate inflation.
There is a constant demand of goods and services in the economy which leads to higher production and higher employment. There is a steady supply of money in the economy which leads to people buying more goods and services.
This phase also sees a lot of fresh investment coming into the corporate sector and in infrastructural spending. This leads to steady growth in the GDP of the country as well.
2. Peak
After a sustained period of expansion, the economy reaches a level where it finds it difficult to grow further. This level is called the ‘Peak’.
In this stage the economy shows fatigue, and every indicator shows signs of slowing down. Fresh investments become difficult to come by, which causes the stock markets to also show signs of slowing down.
The overall price levels in the economy reach their highest point due to which consumers find it difficult to Make fresh purchases of luxury goods.
3. Contraction
After reaching the peak the economy enters the ‘Contraction’ stage. As mentioned earlier, due to high prices the demand for fresh goods and services in the economy starts declining. Hence, situation of high supply and low demand emerges.
This results in a pile up of unsold goods due to which the manufacturers are forced to slow down production. This in turn leads to widespread layoffs and unemployment rates in the economy goes up. The growth rate of the GDP also decreases significantly resulting in widespread gloom in the economy.
4. Trough
The trough is the phase which is brought in by a prolonged contraction phase. At this time, the economy hits its bottom levels and the demand and supply of goods in the economy is at its lowest.
There is very little interest among the consumers to go in for fresh purchases and instead they conserve all their money for meeting there essential needs.
What happens next?
After hitting the trough, the economy slowly starts showing signs of recovery backed by governmental expenditure and some fresh investments made in the economy by the corporates. Those who have surplus money are enthused by the cheap prices at which the goods and services are available, and they start buying, thereby creating fresh demand in the economy.
Backed by this demand, slowly the production increases, new employment is generated and eventually the economy again gets into the expansion phase.
Make your investment decisions according to these phases.
If you were an investor in the stock markets, you need to be aware of these economic cycles and know which phase the economy is currently in. The reason is that the stock markets also react to the changes in these cycles.
Generally, it is seen that during the expansion phase, the stock prices start rising and reach the highest at the peak stage. Smart investors book their profits at this level, and which causes selling pressure on the market. Therefore, the prices start falling and reach the bottom at the trough stage.
Investors get enthused by the rock bottom prices of stocks at this level and they start making fresh purchases to fill up the portfolio with good stocks which are available at low price. This leads to fresh buying of stocks which cause the share prices to move up.
Hence the economic cycles lead to market cycles as well. If you are investing for the short or medium term, then you can benefit from this knowledge and make your buy/sell decision accordingly.
We Can Help
If you think that a lack of tracking all these phases is going to be difficult for you, then we can help you. Finideas has a team of experts who are helping investors like you to make smart investment decisions backed by knowledge like this. Do not hesitate to chat with us if you need any help.
Happy Investing!
This article is for education purpose only. Kindly consult with your financial advisor before doing any kind of investment.
