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How Economic and Business Cycles Influence Equity Prices
Julia O’Neal; MA, CPA with Staff Writers
The equity markets react to the business cycle as it moves through standard phases.
For example, coming out of a recession, when gross domestic product (GDP) is increasing, cyclicals do best, since consumers are fulfilling “pent-up demand” for big ticket items that could be deferred during tough economic times. Conversely, as the economy turns down – so do cyclicals – often slightly ahead of the overall economy.
As inflation heats up in a rising economy, companies can raise prices and profit at first as expenses stay constant. But ultimately inflation raises interest rates and capital becomes more expensive, so companies have to spend more to borrow capital to finance growth. Gentle interest rate increases do not always make the stock market fall, but it will rise more slowly.
However, high interest rates and high inflation ultimately are negatives for the stock market.
A bull market in stocks generally consists of three consecutive phases:
• Monetary: Interest rates are falling, either naturally as inflation eases or with the help of a central bank, like the Federal Reserve, which can artificially lower short-term interest rates.
• Earnings-Driven: Companies have been able to borrow capital cheaply and have spent the down-market time practicing efficiencies, so now they are geared up for growth. Consumers are buying, so earnings are beginning to flow through to the “bottom line.”
• Speculative blowout: The markets are responding to the good earnings reports—sometimes beyond what is justified. P/E ratios begin to get very high relative to a normal market, and markets are “overbought.” Wary physicians and canny medical investors may want to sell stocks to take profits.
According to Goldman Sachs Research, the stock market may peak while the overall economy is still in a growth phase. Since 1952, the S&P 500 peak has led the overall economy’s peak by about seven months. During down markets, high-dividend-paying stocks and stocks of companies that sell necessary goods or services, like utilities and food companies tend to hold their value. These are called defensive stocks.
Conclusion
Fundamental analysis takes into consideration economic factors such as consumers’ ability to buy a company’s goods or services or the company’s borrowing needs at current rates.
How has the recent economic and medical business cycle affected your investments?
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