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Your Money: How business cycles impact market behaviour

Based on the phase the economy is in, certain tweaks in the investment portfolio can enhance positive returns

Your Money: How business cycles impact market behaviour
This phase is characterised by very low to negative growth rates. Interventions in the form of macroeconomic policies are needed during this phase to stop the contraction from intensifying, leading to the next phase, called the trough.

By Madhuritha Murali & Parthajit Kayal

The business cycle refers to the periodic expansion and contraction in the level of economic activities in a country. It is characterised by four phases; namely, expansion, peak, contraction and trough.

Peak: Also called the boom, the aggregate demand during this phase is high and the level of economic activities is at a peak. The growth rate is highly positive but is slowing. In other words, the economy is saturated, and there is increasing pressure for the growth rate to turn.

Contraction: Through this phase, economic activities contract. This phase is characterised by very low to negative growth rates. Interventions in the form of macroeconomic policies are needed during this phase to stop the contraction from intensifying, leading to the next phase, called the trough.

Trough: This is the lowest level of the contraction phase. Industrial production is at the lowest. To stem losses, companies begin laying off workers.

Expansion: After reaching rock bottom in the previous phase, the economy in this phase is characterised by an increasing level of investment, positive and rising growth rate backed by increasing aggregate demand. This is a healthy phase.

Gross Domestic Product (GDP), a measure of the level of output in the economy, is used to identify the phase of the business cycle. A negative growth rate of GDP during two consecutive quarters is taken as an indication of recession. Given the globalisation intensity, there is an increased sensitivity to the business cycle of one economy on the other economies of the world, leading to a co-movement in business cycles across countries.

Market behaviour during different phases
During the expansion phase, there is optimism and confidence in the market leading to a higher trading frequency. The market is bullish. This bullish fever continues through the peak phase too. As the economy enters the contraction phase, companies’ profitability falls, investors tend to sell their stocks. Momentum strategies could be employed to identify any reversal in the market. The 52-week median price point is one such indication. As more people sell off their stocks, prices fall further resulting in a bear market.

Some stocks tend to underperform during certain phases. Small-cap funds are relatively more volatile, and are a good option during the expansion phase. On the other hand, large-cap funds, of industries that are core to economic growth are more stable, and one can invest in them on a long-term basis. Evidence shows that energy and utility stocks have done well as inflation rises and demand continues.

Murali is a research scholar at Madras School of Economics and Kayal is assistant professor, Madras School of Economics

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