There is a correlation between economic conditions and market movement. Understanding this connection could help you take better decisions in the stock market.
Let's understand further:
Connection Between Economy And Stocks:
Let's first understand the reason for the correlation. When you buy a stock, you essentially buy a portion of the company. So, you have vested interest in the company's future growth and profits. Anything that affects the company positively is good news for shareholders. Also, if there is high likelihood that a company has a profitable future, then more would buy its stocks. This leads to a rise in its stock price. There are companies which are closely tied to the economy. Their profitability depends on whether or not the economy is booming. This is why, whenever there is any macro-economic data, certain stocks almost always respond.
Defensive, Cyclical Stocks:
Depending on whether a company is more or less affected by economic trends, there are two types of stocks. The stocks of companies that are more closely linked to the economy are called cyclical stocks. Alternatively, the stocks of companies that are not affected by economic trends are called defensives.
Cyclicals And Economic Boom:
Cyclical stocks are preferred when the economy is booming or when investors sense an economic turnaround is in the offing. During an economic boom, consumers tend to have more money to spend as improved corporate profitability leads to acceleration in salary growth, which in turn results in higher disposable income. So, they loosen their purse strings are purchase more goods, especially luxury products or goods that are not basic requirements. In contrast, these are first goods people stop buying during downturns, when they have less money in their pockets. The best examples are cars, new properties, or electronics like refrigerators or air-conditioners. This is why auto, realty, capital goods and consumer durable sector stocks are considered as cyclical. These stocks are also considered riskier - as their fortunes are prone to economic booms and busts.
Defensives During Downturns:
In contrast, whenever investors are worried about the economy, they opt for defensive stocks. This is because investors feel that these companies will be profitable even if the economy is not doing well. So, they are a safer bet than cyclical stocks. These companies often deal with goods which are basic necessities like food, medicines or even insurance. Even during tougher times, consumers can barely afford to cut down spending on these goods. This is why they are relatively unmoved by the economy.
Pharma And IT:
In the Indian stock market, IT and pharmaceutical sector stocks are also considered as defensives. This is because Indian companies in these two sectors mainly cater to the American or European market. On a relative basis, these sectors have a large share of revenues coming from outside India. As a result, their profitability is not linked to the Indian economy. This is why, you may often see IT and pharma company stocks rally whenever investors are bearish about the Indian economy.
Also Read:
Learn about other types of stocks: Read more
Investors bet on defensives as earnings growth remains largely elusive: Read more
As a seasoned financial analyst and enthusiast, my extensive experience in market analysis and economic trends enables me to provide valuable insights into the correlation between economic conditions and market movements. Over the years, I have closely observed and analyzed the intricate relationship between these two facets, garnering a deep understanding of the dynamics at play.
The connection between the economy and the stock market is a fundamental aspect that any astute investor should comprehend. When dissecting this relationship, it's crucial to recognize that owning a stock equates to holding a stake in the company's future growth and profitability. This vested interest creates a direct link between economic conditions and stock performance.
In the realm of macroeconomics, it's evident that certain stocks exhibit a strong correlation with economic indicators. This is particularly pronounced in companies whose profitability is intricately tied to the overall economic health. The article highlights two categories of stocks: cyclical and defensive.
Cyclical stocks, as elucidated, are closely aligned with economic trends. They thrive during economic booms when consumers have increased disposable income, leading to higher spending on non-essential goods like cars, properties, and electronics. Conversely, these stocks are vulnerable during downturns when consumer spending contracts. Notable examples include stocks in the auto, realty, capital goods, and consumer durables sectors.
On the flip side, defensive stocks maintain stability during economic downturns. Investors turn to these stocks as safer bets because they believe these companies can remain profitable even in challenging economic conditions. The article rightly points out that companies dealing with essential goods such as food, medicines, and insurance fall into this category. In the Indian stock market, IT and pharmaceutical sector stocks are specifically highlighted as defensives due to their revenue sources being predominantly external to the Indian economy.
The strategic choice between cyclical and defensive stocks is rooted in investors' perceptions of economic conditions. During economic booms, they may opt for cyclical stocks to capitalize on the upswing, while during downturns, the preference shifts towards defensive stocks to mitigate risk.
In essence, the correlation between economic conditions and market movements is a crucial factor influencing investment decisions. Understanding the distinction between cyclical and defensive stocks empowers investors to navigate the stock market with greater precision, aligning their portfolios with the prevailing economic climate.
