Navigating the Ups and Downs in the Economy

Changes in the economy occur regularly, but unfortunately they rarely follow any set schedule and they can be hard to predict. At times you may wish you could figure out some way to know when economic conditions were about to change, or what adjustments you should make in your portfolio when a shift appeared to be on the horizon.

It’s a tricky topic, and even economists disagree about the nature and causes of economic cycles. But we can at least take a look at some of the issues you need to be aware of, and help familiarize you with how it all works.

Some people tend to refer to changes in overall economic conditions as "economic cycles" or "business cycles." However, it could be a misnomer to label these changes this way. Because they are not, in fact, predictably cyclical, some economists prefer to call them "economic fluctuations." Regardless of the terminology you choose to identify them with, changes in economic activity generally follow four phases:

Advance or expansion. When times are good and the economy is growing, we typically see indications such as falling unemployment rates and factories taking advantage of excess capacity, to name a couple. While the news during this phase is typically positive, you may soon start to see signs of problems ahead. If inflationary pressures begin to creep in, this is typically when the Fed raises interest rates to help keep the economy from overheating.

Peak. By the time we get to this point, the economy tends to be operating at full employment, factories have used up their excess capacity, and inflationary pressures are building. When rising labor and materials costs squeeze companies’ profit margins, the Fed will usually move more aggressively to slow growth by raising rates to help ease inflationary pressure.

Decline. Slowdown or recession. Ideally, action by the Fed to tame inflation should allow the economy to gradually adjust to a sustainable long-term growth rate without the threat of inflation. In reality, however, the combination of the Fed’s tightening and the need to correct accumulated imbalances in labor and materials supplies typically slows growth to a level that’s actually below the economy’s long-term potential. Unemployment rises, factories slow down, and inflationary pressures ease.

Trough. At this point in the cycle, inventories are depleted. The Fed lowers interest rates to help stimulate the economy, and businesses and homeowners refinance mortgages to take advantage of lower rates. Companies will eventually purchase new equipment and expand operations, helping inventories to grow and marking the beginning of a new expansion.

As you can see, there are some telltale signs that can at least give some idea of where the economy is in its cycle. However, to make matters more complicated for you as an investor, the stock market tends to move in advance of the economy, usually in response to investors’ anticipation of what they see down the road. The biggest challenge is knowing when the shift to the next phase will occur, because predicting the market and the economy is a bit like forecasting the weather.

As an investor, your level of concern for economic fluctuations will depend on several factors. You may pay less attention to them if you have a long time horizon and your portfolio is positioned to weather the ups and downs. Alternatively, you may be able to enhance your returns if you can figure out how to sell investments that do poorly in the next anticipated phase and purchase those that typically do well. Working with a financial consultant could prove valuable if you decide to employ such a strategy. n

This article was provided by Peter Zagrobelny, AAMS (e-mail: of A.G. Edwards & Sons, Inc., Member SIPC.

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About the Author: Peter Zagrobelny, AAMS