How Does The Business Cycle Affect Your Investments

The vast majority of investors always seem to get the signs wrong when it comes to the timing of investments. In this article we’re going to look at the business cycle and identify some of the more common mistakes made by investors.

At the start of the business cycle

In this phase, producers of goods and services start experiencing strong demand. Only the larger companies are participating in the demand at this stage.
Investors are unaware of the opportunity that is knocking on their door. Now is the time to own shares in these large companies. Since the economy is coming out of a recession, most investors are seeking to protect their capital. The majority feel safer in cash than in shares and ‘miss the boat’.

As the business cycle gains momentum

New companies start entering the marketplace. Investors start getting excited and share prices start to climb. As more companies enter the marketplace, the market gets flooded. This means price cuts, which also means a decline in profits.
As profits decline share prices also start declining. Investors now start getting unhappy, but are still heavily exposed to shares.
Slowly demand begins to catch up with supply. Since most investors are disenchanted with the decline in share prices, they remain underweight in shares, preferring cash.
As demand begins to exceed supply, profits start improving. Alert investors quickly realise what is happening and start moving back into shares. The faint of heart choose to remain in cash.
As demand outstrips supply, prices start to rise. Rising prices means bigger profits. Companies start expanding while new companies start competing in the same market. Once again everyone is excited about owning shares.

Now imagine if you could accurately ‘time’ the business cycle?
Unfortunately this is not as easy as it sounds!

However, as I mentioned in my previous article, the Reserve Bank does use various indicators to determine in which stage of the business cycle we find ourselves in.
These indicators are:

1.       Leading indicators.

These indicators signal future events. Bond yields are a leading indicator.

2.       Coincident indicators.

These indicators occur at the same time as the conditions they depict. Personal income is a coincident indicator.

3.       Lagging indicators

These indicators follow an event. Unemployment is the most popular of these indicators!

The problem with these indicators is that the ‘market’ tends to price them in. So by the time a leading indicator indicates that we are entering an ‘upswing’, the share price usually reflects this optimism by costing more than usual.