How Economic Cycles affect Investing

Economic cycles have been with us since the beginning of recorded history. In ancient agrarian times, they were identified by periods of bumper crops followed by episodes of drought or pestilence. Today, we track these cycles by the relative strength or weakness of our current medium of exchange, money. In times of economic boon – which typically last an average of about four or five years – people often become lulled into a false sense of security, believing that the good times will go on forever. Jobs are abundant. Workers ask for and receive higher wages, making more cash available for the purchase of goods and services. Additionally, more people invest in the stock market, causing it to go up – a direct reflection of the public's rising expectations.
More investor purchases work to create more demand, which pushes prices even higher. Because of this, every investor believes that he or she will be able to sell at a profit to someone else later on (the so-called "greater fool theory" in action). They begin to ignore the fundamental value of what they're purchasing, thinking that they're buying future profits. Then, when high expectations are no longer being met, prices begin to drop. Investors who are unsure of themselves or their assets panic and start dumping them. This pushes prices down even further. Eventually, the economy finally runs out of steam and begins to falter.
There are a number of causes that might precipitate these occurrences. For instance, labor or material shortages and demands for increased wages could slow down business productivity. External factors, such as economic embargoes, might create additional shortages. And acts of Congress (such as tax increases) or the Federal Reserve (in regulating the nation's money supply and interest rates in an effort to slow down the economy or stave off a contraction) can dramatically affect economic cycles.
Since the post-World War II era began, economic contractions (more commonly known as recessions) have lasted an average of less than three years. During this cyclic downturn, the greater and more widespread the public's pessimism, the lower prices sink. Once prices have nearly bottomed out, most investors typically find that they either have no money left (because they've lost it in the market's fall) or, if they do have money, they're too pessimistic or scared to invest further. Only after the market has made a recovery and prices begin to rebound does the general investing public come back. When that happens, the cycle begins all over again.
It's important to note that, historically, each subsequent boon has reached a higher level than the previous one. The savvy investor realizes this and maintains a long-term perspective. In good times he or she will act conservatively by avoiding the speculative fervor of the masses, and in bad times will adopt the attitude that investment opportunities are being created for long-term gains. In this manner, the careful investor will avoid getting hurt during temporary economic downturns, and may even build a position to take advantage of them. Over the long haul, his or her assets will grow in value along with the overall net growth of the economy. Many financial advisors emphasize the wisdom of long-term investment for this very reason.