The stock market is forward-looking and often categorized as a leading indicator of the economy. As investors, we invest for the future and not for the present; however, we need to know if the future looks bright or if we need to brace ourselves for some pain. Understanding how the economy changes over time allows us to do so.
The business cycle
We can break the economy's health into four phases that occur in cycles, with one phase following another. The four phases are: expansion, peak, contraction, and trough and are collectively known as the business cycle. While the concept is straightforward, economists, investors, and people use varying terminology to describe this cycle. A simple way for us to make sense of the business cycle is to imagine it as climbing up a mountain range. We could be going up towards the top or coming down towards the bottom before climbing the next mountain.
Let's visualize the cycle first and then look at the terminology.
The expansion phase is marked by increased productivity, increased spending, and investing from both the private sector as well as the government. This phase is shown as the upward sloping part of the graph where aggregate economic activity is increasing.
Near the top, we arrive at the peak. The peak is signaled by continued slowing of growth down to 0 before growth turns negative. The peak is often called the boom.
After the peak, the economy undergoes a contraction, which can be referred to as deceleration or a recession.
During a recession, jobs are scarce, housing prices drop and both consumers as well as businesses spend less and save more.
The trough, or depression, is the very bottom of a contraction right before the cycle turns over into expansion again. Troughs are signaled by slowly increased economic productivity. The increase will eventually lead to an expansion or recovery and the cycle repeats itself.
Why are markets cyclical?
Markets are cyclical due to static effects, shocks, and economic policymakers. Previous shocks include the Mortgage/Financial crisis in 2008 that launched a global recession that lasted for years. Most recently, COVID-19 is a shock that started global economic contractions.
To counteract shocks and stabilize the economy, the central bank and the federal government implement both monetary and fiscal policies.
The central bank
The Federal Reserve is the central bank in the US. It is the primary government economic policymaker in charge of making sure that inflation and excessive unemployment are under control.
The Federal Reserve enacts monetary policy, or policy governing the money supply in an economy. Quantitative easing is an example of a monetary policy.
The Federal Government is different than the Federal Reserve and enacts fiscal policies. Fiscal policies target the total level of spending in an economy.
Combined, both policymakers are necessary to keep the economy on track. An easy way to think about the relationship between the two is that the central bank, monetary policymaker, makes money available while the federal government works on distributing that money and determines how the money is being spent.
Knowing where the economy is in the cycle is helpful when considering your investment options. For instance, stocks tend to perform well during expansions, while protective investments do better during contractions.