The Economic Cycle and How it affects the Stock Market
There will always be another recession and that recession will always affect the stock market. How do we know there will be another recession? Recessions are part of a normal fluctuations in economic activity, this is known as the Economic Cycle. The word “Cycle” means it happens again but it also implies there are other stages that make up the cycle.
There are 4 main stages of the Economic Cycle:
- Expansion
- Peak
- Contraction (Recession, Depression)
- Trough (Bottom)
If an individual knows and understands the cycles, this information may help him/her become a better investor as the overall Stock Market responds mostly hand-in-hand to changes in the overall economy and it usually reacts violently to recessions.
Predicting recessions years in advance and with an exact date is impossible but knowing where the economy currently stands and where it’s heading within the next few months is a more manageable task. So when it comes to predicting the next recession, make the analogy of predicting rain (without the weatherman’s help): if it’s windy and we see dark clouds, one might say that it’s going to rain, we don’t know what time or how hard it will rain but we’ll know the rain is coming.
We can’t go through all of the Indicators, Statistics, Data, etc. that we would go through because it would take a lot more than a few pages in this website to go through everything but we promise we’ll go through some very important points and we’ll still keep it interesting. In this article, we will concentrate on the FED since it is maybe the easiest thing to explain and is somewhat of a good indicator to warn you if things may be going wrong (although definitely not all the times, so please take this info with a grain of salt, and if you’re interested, you can take our courses where we go into detail about how to spot a recession in a better way).
FED, FED, FED
The Federal Reserve Board (the “FED”) is without a doubt one of the most important things to look at when trying to figure out where we’re at and where we’re possibly going with the Economic Stages. The power of the FED is so great that it can create or postpone recessions practically by itself. Many professional investors follow closely every move by the FED and retail investors should too.
The FED determines Monetary policy (to be more precise, the Board of Governors of the Federal Reserve System determines the policy). In other words, the FED determines the availability (supply) of money for businesses and consumers. We don’t have to get into the details on how the FED works for the purpose of knowing the stages of the Economic cycles but the important thing to know is that whatever the FED does has a profound effect on the Economy and on the Stock Market.
To help us picture the role of the FED in the economy, we need to think of Money like a collectible. For example, imagine there is a Rare stamp and that’s the only one stamp known to be in existence; say the stamp is sold at auction for $1 million. A few months later, someone finds a room with tens of thousands of stamps and they are all the same type of stamp that was sold for $1 million a few months back. What do we think will happen to the price of the stamp that was sold for $1 million? What do we think will be the price of the newly found stamps at auction? Because there is now an abundant supply of stamps, then that “Rare” stamp is no longer rare and therefore no longer valuable because a lot of people can now own one.
Essentially, that’s how Money also works and why the FED is constantly trying to regulate the supply of Money. If there are a lot of Dollars in circulation (it doesn’t have to be physical money) then Dollars won’t be as valuable because everybody has dollars “in their pockets”. If there are not enough Dollars available, then the value of the Dollar goes up.
Because the Dollar is money, someone can’t “buy” dollars with more dollars, one can only do it with another currency. So, the value of the dollar is always compared to some other currency. One can also indirectly compare the dollar with the cost of buying something between two certain points in time.
Why is the Fed so worried about the Value of the Dollar that it needs to Regulate it Indirectly?
In a nutshell, if the Dollar becomes expensive (i.e. the value is higher than another important currency) then Americans are going to be able to buy more foreign products because those foreign products are priced based on their local currency; However, this means Americans won’t sell as many products to the rest of the world. The other problem is, more money available “in people’s pockets” means people will spend more money creating an increase in price in goods and services that is not sustainable because eventually the cost of the services and products will be so high that less people will be prone to spend more money.
If the value of the dollar increases too much (i.e. The supply of money is low) then American businesses will eventually be forced to reduce their prices at a loss and lay off workers which could lead to an increase in unemployment. Less people with jobs means less people spending money which means businesses keep on losing customers and so they keep on laying off people and reducing prices. This is one way a recession might start to occur. Usually this is a Deflationary period.
Now this is not currency manipulation. The Fed main objectives, also known as mandates, are to maximize employment, stabilize prices, and provide moderate long-term interest rates. The FED is not trying to affect the Dollar to be in competition with other currencies but it’s policies to support the local economy end up indirectly affecting the value of the dollar.
What does the FED do to avoid in this case a catastrophic Collapse of the Economy?
It will usually lower the Discount rate as its first tool while at the same time lower the fed funds rate (The Discount rate is the interest rate the Federal Reserve Charges commercial banks when lending them money in the short term; not to be confused with the Federal Funds Rate, which is the interest rate Commercial Banks charge each other for overnight loans of over $1 million; Not to be confused with the Prime Rate, which is the Interest Rate Banks charge their best corporate clients) .
Lowering the Discount rate and corresponding fed funds rate should result eventually in an increase in supply of Dollars which in turn will lower the value of the Dollar. A cheaper Dollar means now US based businesses can sell products/services to the rest of the world at competitive prices which means more sales, more income, more hiring of employees, etc.
The other effect of a lower US Dollar is that businesses will have access to loans at a much lower interest rate which means they will be able to expand, make more money, employ more people, etc.
The money supply is also important regardless of whether the country’s exports/imports because an over abundance of available money in the country would lead to price increases because there would be high demand but low supply of products; the opposite is when there is an over supply of products compared to the demand then businesses cannot sell those products and would have to lower prices at a loss to be able to sell them.
In other words, if people have plenty of money, they’ll have plenty of money to spend, which will increase the cost of things. When the cost of things is too high and/or people don’t have a lot of money, then the cost of things will have to go down to incentivize people to buy again (i.e. this would be a recession).
Further clarification word: The FED cannot alter the Fed Funds rate directly by just saying they will lower/increase the rate. The only thing the FED can directly control is the Discount Rate, which is usually 1% higher than the Fed Funds Rate. The Fed Funds rate is achieved by the FED from an army of traders working at the fed trading, and hence, manipulating, the treasuries, usually the 3-month treasury bills.
What happens to the Economy after the FED lowers the Discount Rate and Fed Funds Rate?
After the economy finds its footing again by employing more people, businesses selling more things and getting rid of excess inventory, etc and we have a full recovery then eventually we’ll get to the point that because the dollar is so cheap, meaning, there’s an oversupply of dollars in the market (people and business take on more loans because the interest rate is low, people make more income and so they spend more, businesses are selling a lot of things to other countries, etc) businesses start charging more money for their services and products.
If the price of goods keeps increasing then eventually people will not want to pay for those products and services leading to another recession. This would be an inflationary period because the dollar keeps on losing value and businesses are forced to increase the value of whatever they offer. The FED therefore tries to mitigate this Strong recovery in the Economy by increasing interest rates (i.e. increasing the Discount Rate directly and indirectly trying to increase the Fed Funds Rate).
What happens to the Economy after the FED increases the Discount Rate and Fed Funds Rate?
After the FED has been increasing interest rates for a while then we start the Cycle again: The Dollar is too expensive therefore Americans buy more foreign goods but sell less American goods to the rest of the world, people don’t have money to spend so they can’t buy more products, businesses are going to be forced to lower prices, lose money, lay off employees, etc, etc. and we get another recession, which the FED will try to avoid or dampen the impact by first lowering the Discount rate and Fed Funds Rate, as we discussed previously.
Overall, the FED has the delicate job of making sure the economy is growing but not growing too fast nor growing too slow.
The FED and the Stock Market
The graph above is similar to the graph shown earlier in this article, except we’ve added the performance of the S&P 500. Notice the scale on the right side, which is for the S&P 500, is a logarithmic scale so the change in values is more pronounced than visually apparent. But the take away from this graph is that most of the times, a recession is preceded by a long stretch in the increase of the FED Funds Rate along with an increase in Stock Prices (S&P 500), and a recession usually hits just after when the FED starts lowering again. During the recession, the discount rate and Fed Funds rates are usually lowered and stock prices decline as well.
Again, there is no silver bullet, not one graph that will tell you everything you need to know. This graph, for instance, shows times where the Fed Funds rate was going up and then down and yet no recession ever happened. In other instances, it shows the Fed Funds rate actually increasing very close to the recession (particularly in the mid 70s early 80s, where inflation was very high but economic output was low… aka, stagflation). And even in some cases when the Fed was lowering the interest rate because they were correctly trying to soften the blow of a recession, even then, the Stock Market sometimes had already dropped. So, while 80% of the time the FED was pushing the rates down when a recession occurred, 50% of the time that the FED was lowering the rates no recession happened. If you were to err on the side of safety, when you see the FED lowering the rates it should give you warning.
So again, don’t time the market simply by looking at the Fed, but the Fed certainly gives you a big warning that something is going on and a Prudent investor would want to research further to see if getting out of the market is warranted.
There is another notable anomaly in the graph: Black Monday, which occurred in October 1987. You can see there was a big drop in the Stock market but no recession. Economists seem to agree in general that a Recession was averted thanks to the FED not only for lowering the interest rates (i.e. the Fed Funds rate) but also because the FED facilitated the flow of money between banks and brokers.
Why can’t Recessions be averted all together?
Let’s make the Train analogy (normal trains, not the bullet trains). Trains are heavy; They are very slow at accelerating because they’re carrying all that weight. Once the Train gets going it carries momentum and it goes fast. If it wants to stop it’s going to take a while because of all that weight behind it.
The economy is similar. It takes time to get it going and it takes time to slow it down. A lot of the data is also from the past so, you don’t know you’re in a Recession maybe until a few months into it (For example, GDP Readings are not available until 3 months after the data is collected).
When the FED realizes the country is in a recession then they start adjusting the Fed Fund rate. The truth is, they don’t know exactly what the interest rate should be and so frequently, as more data is available, the FED might keep lowering the Rate; the same is true when the economy is in recovery, they really don’t know when or how much to increase the interest rates until they have more data available.
In 2008, when the FED got more data showing the world was going to hell in a hand basket, they started using other tools to free up the supply of cash faster than just lowering the interest rates; in this case, they used Open Market Operations, by buying US Mortgage backed securities (and conversely, when the FED Sells Treasuries, the money supply is reduced because funds are pulled out of commercial banks’ reserves to pay for those securities).
Since we’re in the topic of the FED toolkit, the other tool available to the FED is changing the reserve requirements of commercial banks. This is money that banks have to leave in deposit with the FED. If the FED increases the reserve requirements, then these banks will have less money to lend, which means higher interest rates for those loans, which in turn will result in a reduction in the supply of money in the market.
Not the Whole Story
We want to emphasize again that Investors can’t look at one graph or one set of data and swear by it. Basing the investing or trading strategy on one graph or one set of data will more than likely make one lose a lot of money. Professional Investors, Managers, traders, etc. look at a multitude of data. The leading, Coincident, and Lagging indicators alone are a couple of dozens amounts of data.
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