Sunday, March 1, 2009

Stock Markets and Business Cycles

We all talk about Business Cycles and most of us including Harvard educated economists fail to spot the course of its direction. In this scenario, I do not think average retail investors have ideas about business cycles and its relevance with the stock market. I aim to bring more general view of business cycles and stock markets to understand the future that lies ahead of us based on the history.

What does Business Cycle Mean?

In simple terms, we can define it as the uphill and downhill travelling of our economy or economic activity for a certain period of time in a long term growth trend. I can in fact compare this with the way human life shapes up.

Example: Assume a single human life as a separate country. Majority of the people, irrespective of the status of the individual have ups and downs in their life but the long term growth both physically and financially remains intact. Sometimes our growth is more than what we anticipate (Boom Phase) and sometimes nothing goes right whatever we try (Recession). But between good and bad times, we see normal days with little hiccups (Sideways movement of stock market). The reason I relate single human life with a separate country is, the magnitude of ups and downs vary with individuals so as the Boom and Recession phase of a country.


Image Source: Google Images

If you are someone who wonders why I see relevance between human life with business cycles and stock markets when we can find some other economic concepts, then I specifically choose simple law in economics which is Law of Diminishing Marginal Utility. There is a strong relevance but with a small difference.

In simple terms, law of Diminishing Marginal Utility states that interest or satisfaction on consuming something declines marginally with each additional unit. The relevance is “There is a Limit for everything”. There is also one more closely related law which is Law of diminishing marginal returns which says that a firm or company might reach a place from where each additional unit of input would bring less return than the previous unit. Same thing applies to the economy as well. There is a limit for everything and if it goes upwards, then it should and it will come downwards because we are the ones who shape the business cycles. Many think that business cycles happen just like that and people do not have any part in it which is wrong. Consumer behavior is the one which shapes the business cycle patterns.

The two simple laws which I mentioned above have relevance with the aggregate demand which shapes the economy as a whole. All these concepts like Boom, Recession, Trough and Expansion are simple to understand just like what happens in the micro level. Consumers are the ones who create the demand which shapes the production of companies and employment. If the consumers have positive feel good factor, then they just spend more money thus increasing the aggregate demand. To meet the demand for the good, companies employ more people and produce more which gives the positive economic outlook and we call it as boom.

The positive outlook eventually leads to over supply of everything including goods, houses, credit and loans (More Money Supply). As I said in the Law of Diminishing Marginal Utility, people reach a place where they do not create the same aggregate demand and start to spend less which forces the companies to cut production and layoff employees because of Law of diminishing marginal returns. The person who does not have work, of course will default on loans and mortgages as they have no means to repay it which leads to the recession and some companies go bankrupt and some survive. Hence, consumers are the ones who shape the economy. You might ask, if consumers are the ones, then why the hell you and I can’t predict?

The reason is simple. If you and I are the only consumers in the market, then of course we can predict perfectly what is going to happen. But in reality we have about 7 Billion consumers around the world and each one behaves differently and has different tastes and preferences. They all act differently at various points but act similarly if there is a popular sentiment regarding the market. If people feel good about the market, then they spend more and save less because they are confident that they will get work consistently and save money in small amounts. They just want to enjoy more at present. But if they feel bad about the market, then they save more and spend less as they plan to survive the bear phase if they lose the job. So, in essence consumers linked aggregate demand, employment/unemployment, production and government actions are the ones that shape up the Boom or Recession.


Image Source: Google Images

The graph explains the phases of business cycle which identifies the culprit who is responsible for boom or recession which is Aggregate demand and aggregate Output and we discussed it enough. But let’s look at the X axis which is labeled as Time. Now you should understand why people invest for long term. Business cycles come and go but the long term growth remains intact. If you have selected GOOD COMPANIES to invest in, then you should be confident that you might get good returns over long term. Of course people who exit at the peak and buy it back at the bottom which is a different story and only select few can do that. If everybody who enter the stock market earn OVER A LONG PERIOD OF TIME, then there won’t be any stock market and we need to coin some other term for that.

Relevance of Business Cycle with the Stock Market

By now you might have understood the relevance of business cycles with the stock market. If not, here is the brief description. As I said earlier, if the aggregate demand is more, then companies employ more people (People earn money) to produce more which increases the company earnings. People are positive about the stock investments as they believe in the future growth and start investing on stocks.

Too many people chase the stock market thus increasing the stock price. Some people make profit and some not. Once the companies start cutting production due to decreased aggregate demand, earnings become less both for companies and people which influences the investor decision to exit the stock market to cut their loses. Many people lose money and if you are the one who earned money after investing in a peak, you can claim yourself that you are next to none in stock pickings. In short Boom gives the positive outlook for the stock market while recession gives the negative outlook.

When will we get out of this recession?

According to National Bureau of Economics Research (NBER), there have been 32 cycles since 1854 and all have followed the same pattern keeping the long term growth intact. The average period of contraction (Peak to Bottom) for those 32 cycles is 17 months. The following table gives you the business cycles associated with various time periods and the average time taken for each of the actions. If you look at the 1945-2001 period (We are associated with only this period), the average time taken to hit the bottom from peak has been 10 months.

But have we hit the bottom now? NO. That itself proves that the situation we are in is comparable to 1854-1919 period and it can be even worse. But what we can be sure of is there is always a tomorrow. Remember that India or few other countries could not have experienced the same kind of impact during these very early periods (This table is Associated with US). Do you know the reason? Because, countries had less international trade relations then than now.

Note: Comparing periods often can be misleading in the sense, governments did not resort to any serious regulatory action during the earlier periods which is not the case now. Also please look at the currency standards then and now.


Table 1. Business Cycles Average Recovery Time Period



Source: NBER

Conclusion: If we compare the present situation to the worst period (1854-1919), then we should hit the bottom during the last quarter of 2009 considering that previous peak ended in 2007 December. But if we compare ourselves with the overall history, then we should hit the bottom by the end of 2009 second quarter. In my view, nobody can predict exactly when these things will happen. But I can guess that the economy might improve by 2010 first quarter onwards and if you are an investor who is new, you can wait for some more time before plunging in to the stock market. If you are an experienced investor who does not mind about time, then you can buy good companies even now.

Kumaran Seenivasan.

6 comments:

Shabu's March 6, 2009 at 11:20 AM  

Excellent....Logical and informative as usual.. Keep it up...

Shabu's March 6, 2009 at 11:20 AM  

Excellent....Logical and informative as usual.. Keep it up...

Yashwant October 28, 2009 at 11:27 PM  

Kumaran

You are doing great job.

I am beginner in Stock market.

YOur article are inspired me a lot.

Keep writing such a artiles.

Thanks and best of luck.

Yashwant

jaylinuxguru November 23, 2009 at 8:15 AM  

Really great articles. You are doing a great work. Instead of speculating your articles have some very basic fundamental analysis.

Sam August 11, 2011 at 3:38 AM  

Thanks for sharing your ideas on stock markets and business cycles. It's always important to have these reports so you may know the status of your business.

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