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Business Cycles and Stock Picking

26 Jun, 2017

The Indian economy or the economy of any major country throughout the world is said to work on a cyclical pattern which repeats over and over. While it can be very difficult to predict the timing of this cycle, investors who can recognize it can use it to gain a financial advantage in many different ways, like picking stocks. This is because even the finances of the companies behave in a similar way to the economy of the country.

There are basically four different phases of an economic cycle and the same phases are duplicated in business cycles too.

1. Expansion

This is the phase when the economy of a country starts to recover from the recession. The RBI starts easing up the monetary policies, making credit more available. This helps in injecting liquidity into the economy which encourages growth and increases earnings of the companies. This then leads to the stock markets rising and improvements in the economic numbers.

2. Peak

The expansion phase is followed by the peak when the growth finally begins to taper and even the business earnings have reached their peak. The interest rates are at the lowest and consumers continue spending. The stock prices generally level off and most of the times start to retrace their recent growth. As compared to any other phase of the cycle, the peak phase lasts much longer.

3. Contraction

Eventually, the economic growth slows and inflation starts to increase. Unemployment increases and economic numbers begin to fall.

4. Trough

This can be defined as the recession period when the economy of the country bottoms out. The supply of money dries up and the RBI starts increasing interest rates to reduce inflation. Markets hit low as even the company profits start falling and consumer spending reduces.

Profiting from the Economic Cycle

While investors who do not understand this economic cycle can still earn excellent returns over a long period of times, people who adjust their investment for every phase of the cycle achieve far superior returns in shorter periods in several cases.

For instance, companies involved in entertainment generally see their business improving during recessions. This is because, during the recession, people generally look for things that can make them forget their financial troubles even for a short time and entertainment seem like a viable option.

As an investor, you can use your knowledge about the economic cycle during the recession by focusing on the interest rate. RBI generally reduces the interest rates to accelerate growth and when the interest rate falls, the bond prices increase. This means that it can be an excellent time to invest in bonds. When the economy reaches its peak, you can then sell the bonds as the interest rates will probably increase and the bond prices will fall.

If you want to pick stocks based on the cyclical, you can pick good financial companies during the growth phase as these companies are highly sensitive to the interest rates. When the interest rates will fall, the number of people who want to take a loan will increase and this will significantly improve the profits of the financial institution. Moreover, it has also been observed that the stocks of such companies often rise much faster as compared to the whole financial market.

 

Economies all over the world have moved as per the phases mentioned above for hundreds and thousands of years. If there is one skill that you want to learn as an investor, make sure that you try to understand the economic and business cycles as this knowledge has been helping experienced investors earn handsome profits on a regular basis by allowing them to understand the sectors which will benefit from the current economic phase.

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