You must be wondering why I am publishing this post on a Making Money blog… Your doubt is absolutely justified. If you give me a chance to explain, you would agree that we brainstorm (on this blog) on how to make more & more money. And money is obviously related to the overall economic health of a country – and hence one must have a brief idea of what is going on and why. If the economy is not in a good health (as the situation is now), you may not make good amount of money, in fact you may lose whatever you already have. However, though falling stock markets often are a good excuse to invest more, you should think thrice before taking any step related to your money. You may find some tips to do so at the bottom of this article…

The business cycle (also known as economic cycle) refers to the fluctuations of economic activity about its long term growth trend. The cycle shifts “continuously” from periods of relatively rapid growth of output (recovery and prosperity) to those of relative stagnation or decline (recession) and back to rapid growth. These fluctuations are often measured using the real gross domestic product. However, these cycles do not always strictly follow predictable pattern – and that’s the key why renowned economists also fail to “predict” future economic activity…

The economic cycle, most of the times, follow the following stages (as shown in above image):
Growth (expansion), Peak, Recession (contraction), Trough and Recovery

Since the Second World War, most business cycles have lasted three to five years from peak to peak. The average duration of an expansion is 44.8 months and that of a recession is 11 months. As a comparison, the Great Depression - which saw a decline in economic activity from 1929 to 1933 - lasted 43 months from peak to trough.

Explaining business cycles

The explanation of fluctuations in the aggregate level of economic activity is one of the primary concerns of macroeconomics. The most commonly used framework for explaining such fluctuations is derived from Keynesian economics. In the Keynesian view, business cycles reflect the possibility that the economy may reach short-run equilibrium at levels below, or above full employment.

What causes recessions to recover?

Productive capital used by firms gets worn out over time and require replacements. Spending on capital equipment such as machinery is necessary, which increases aggregate expenditure (AE) and causes the economy to slowly climb. Secondly, the low prices characteristic of a trough phase causes increased demand for them, resulting in inflation which is characteristic of the boom phase. Lower interest rates stimulate increased borrowing. The repayments and interest which need to be paid back contribute to the rise in AE. Governments aim to improve the business cycle so as to provide stability, get re-elected and to ease worries about the state of the economy. They also do this to attract foreign investors and improve their international reputation. (Source: ICICIDirect University)

What it means for the Retail investor?

By examining empirical evidence, the investor can attempt to create a framework for viewing present and future events as they unfold. There are two key questions the investor may want to ask:

1. Will the historic pattern hold, or will it be altered? To answer that, you’ll need to ascertain whether the factors driving today’s market are fundamentally unchanged, or whether the situation has evolved incrementally or even been radically changed.
2. Has the market already taken the anticipated future events into account? If the factors driving the industry are the traditional cyclical ones, the market usually will have taken them into account, because they are expected. If the factors represent a new element in the equation, then the market may not be expecting them and may not have adjusted accordingly.

… To be continued …