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:
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.
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.
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.
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.
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.
Learn about other types of stocks: Read more
Investors bet on defensives as earnings growth remains largely elusive: Read more
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