Basic Economic Concepts - 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 Cycle's 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.

Inflation
Inflation refers to a general increase in the price of goods and services. This occurs when demand for these items grows faster than the supply. The result is more money chasing fewer goods, and therefore prices increase. Ensuring that your client's investments outpace the rate of inflation over the long haul is one of the major challenges for an IA.

The most important measure of inflation is the Consumer Price Index (CPI). The stock and bond markets are very sensitive to changes in the CPI because when inflation rises, purchasing power is eroded. The ensuing drop in consumer spending has a negative effect on stock and bond prices.

For more on the CPI, such as how it is constructed, its uses and how it can be used to protect against inflation, refer to the article Why the CPI Is a Friend to Investors.

The rate of inflation tends to increase during economic expansions and decrease during recessions. Inflation tends to be moderate during expansions, and high inflation rates tend to hasten the transition from peak to recession. Deflation is rare and occurs only during recessions.

What causes inflation? How does it affect your investments and standard of living? The All About Inflation tutorial has the answers.

Interest Rates
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