Back in Economics class in school, the professor used to throw around a word a lot: cyclicality.

The word stuck in my mind to this day. It’s just not a term we often use in everyday life. In fact, I have never used the word except when discussing economics and investing.

But it’s important for investors.

The dictionary defines cyclicality as: “The quality or state of something that occurs or moves in cycles.” For example, the ups and downs (growth and recession) of an economy is its cyclicality.

Correlation of Economy and Stock Market

Although the correlation isn’t always very strong, for stock investors it helps to know how the economy is doing. Expectation of economic growth tends to be good for the stock market. On the other hand, expectation of economic contraction tends to be bad for the stock market. This is because when the economy is growing, companies typically enjoy higher revenue growth. And when the economy is shrinking, revenues and earnings typically fall. Weaker companies could even go out of business.

This is why analysts and investors pay close attention to economic data and keep close tabs on how the economy is doing.

But sometimes the market and economy can go in different directions.

Fiscal and Monetary Stimulus

Sometimes, a stock market can rally even though the economy is shrinking. A prime example is the recent recovery in the market despite the worst economic contraction in history as a result of lockdowns caused by the pandemic.

Unprecedentedly huge fiscal stimulus provided some relief to businesses and families and gave the market confidence that Washington will pull out the big guns to help the economy.

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Even more important to stocks, the Federal Reserve has pushed the pedal to the metal. In March, the Fed announced that it would buy unlimited amounts of bonds (Treasury securities and agency mortgage-backed securities). This is the “QE Infinity” you might have heard about on the news. The announcement marked the beginning of the remarkable market rebound that has taken stocks back to all-time highs.

By buying up incredible amounts of Treasury securities, the Fed injects great amounts of cash into the financial system. The action also pushes Treasury yields down…way down. Since the Treasury yield serves as the benchmark for many interest rates in the real economy, this means interest rates are falling too. (Compare the bank interest you were receiving at the end of last year to what you are getting now.)

Super Low Treasury Yields

In fact, at the latest inflation (Consumer Price Index) reading of 1.4%, you are getting a negative real interest rate when you buy even a 10-year Treasury note, widely regarded to be “risk-less.” Yeah, maybe you don’t have to worry about the U.S. government defaulting, but you are losing purchasing power!

Thus, when investors are getting nothing or even negative return for “safe” investments like Treasurys, risky assets (such as stocks) become more attractive because they offer the potential for far higher returns. Plus, with all the liquidity injected into the financial system and low interest rates, it’s cheap to borrow money to spend and invest, which helps stocks and the economy.

But even with unprecedented fiscal and monetary stimulus in place, the economy eventually needs to rebound. If investors didn’t expect the economy to come back once the pandemic starts to be brought under control, the stock market would likely not have rallied as strongly as it did, despite QE Infinity.

We Still Need an Economic Recovery

The market is forward looking. This is why it can go up even if the economy is currently very bad. A rallying market says that it thinks things will improve economically in the next few quarters.

The rally over the past seven months, besides the support from the government, implies that investors are pricing in a strong economic recovery. If the market starts to lose faith in this expectation, stocks could fall again.

Consequently, it helps to be discriminating about the stocks you are buying and to continue to diversify. Ideally, have a stake in some stocks that aren’t very sensitive to economic cycles. These kinds of stocks tend to do well in good times or bad.

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