Economics and The Time Value of Money - Business Cycles
Changes in the business cycle impact the return of securities in different asset classes. We'll discuss the business cycle's effect later in this chapter.
The business cycle has four phases:
- Expansion - this phase begins after a low point in the economy, and is characterized by increased economic activity and real GDP output increases.
- Peak - this is the phase where the growth rate of the expansion slows and the economy is in a period of prosperity.
- Contraction - this follows the peak and is characterized by a reduction of the GDP, as well as other business indicators. Also known as recession.
- Recovery - this is where the contraction reaches bottom and may be stagnant for a time before starting the next expansion (also called a trough).
Phases of the Business Cycle
The term "recession" may refer to the contraction stage in the business cycle, but it also refers to a prolonged drop in GDP that lasts at least two quarters.
The Effect of the Business Cycle on Stock Markets
The stock market tends to be a leading indicator of the business cycle, since investors look to other indicators and tend to exit the market at or before an economic contraction and return to the market during recovery.
Sources of the Business Cycles Impact
- Investor Expectations: Essentially, investors move money based on where they see future profit (or loss) potential. Such movements can then affect the overall market itself, since more dollars entering the market tends to drive stock prices higher.
- Inflation expectations are another source of business cycle impact on the stock market.
- If it is assumed that inflation will rise in the near future (see the sections below), interest rates tend to rise, and this has a negative impact on stock (and bond) prices.
- Ironically, people look to stocks as an inflation hedge, but stocks actually do poorly during periods of high inflation.
- Of course, over long periods of time, the return on stocks does beat the general rate of inflation.