In poker,you've got to know when to hold 'em, and know when to fold 'em. Sometimes, even when you have pocket aces, you know from reading the other players that the time isn't right, and you've got to lay 'em down.
In some ways, the stock market is the same. You've got to know which way the economy is headed before buying even the most well-researched stock. Even the best mutual funds can lose during a downturn. Find out how to read the economic tea leaves, and you can confidently go all in with your stock picks. Here's the top tips for using your knowledge of the economy to invest in the stock market.
Know Where You Are in the Business Cycle:
The economy, and therefore the stock market, follows a regular business cycle. There are four phases :
- Expansion - The economy grows a healthy 2-3%, as measured by GDP (Gross Domestic Product). Inflation is 2% or less. The stock market is in a bull market, while bonds are in a bear market. Commodities, especially oil and copper, usually do well.
- Peak - GDP growth is 3% or more, while inflation is 2% or grdater. This phase is difficult to gauge, because it could last a year. However, this is the best time to sell stocks and move into bonds.
- Contraction - GDP growth is slower, prices are dropping, and deflation is a threat. Interest rates drop as everyone rushes into safe havens such as bonds, gold, and the U.S. dollar via Treasuries.
- Trough - GDP is negative, unemployment rises, and businesses close. It's time to transfer out of the safe havens and pick up other assets, such as mutual funds that track oil companies, stocks and perhaps some foreclosed homes.
Track the Top 5 Leading Economic Indicators:
The leading economic indicators will tell you what phase of the business cycle you're in. Here are the top five: durable goods order report, interest rates, manufacturing jobs, building permits and the S&P 500.
Your best bet is to make sure your investment portfolio is balanced and diversified. This means you have a good mix of investments that respond to the business cycle the same way. You must diversify in several different directions. First, have a mixture of stocks, bonds and commodities. Second, make sure both your stocks and bonds have a mixture of U.S., international and emerging market companies. Third, your U.S. stocks should be from small, mid and large companies. Fourth, the U.S. stocks should also be divided between value and growth companies.
It's best to work with a financial planner to create a mixture that meets your investment goals. For example, if you aren't planning to retire for 20 years, you'd select a higher percentage of small and emerging market stocks, since they are riskier but give the best return. On the other hand, if need to live off of your investments, you'd want more bonds and U.S. large companies, because they give a steadier stream of income, although they return less over time.
Maintain Your Asset Allocation:
As you go through the business cycle, these different asset classes will shift from your original mixture, known as your asset allocation. For example, many people found that in 2006 the equity in their home grew to 50 - 70% of their total net worth. That would have been a good time to sell, move into a smaller home or rent, and invest in bonds. Every six months or so, visit with your financial planner to rebalance your portfolio.
Know the Warning Signs of an Economic Crisis:
Most economic crises are preceded by some kind of asset bubble. For example, before the 2008 financial crisis, housing prices skyrocketed. Before the 2001 recession, high tech stock prices went beyond any rational basis. The best way to differentiate between an asset bubble and healthy growth is if it seems everyone is making money from the asset class, and you feel like you've been left out. It's also helpful to study past economic crises,such as the 1989 Savings and Loan Crisis, the 1970s oil crisis and stagflation, and the Great Depression of 1929. Article updated September 3, 2013
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