Boom and Bust Cycles Definition
Boom and Bust Cycle is the Gross Domestic Product (GDP) cycle of upward and downward movements along its long term trend and helps identify the level of production in the economy and the performance of the associated economic indicators such as employment, inflation, stock performance, and investor behavior.
Explanation
Below is an image of the GDP Cycle, The straight line is the potential GDP, which is upwards sloping implying progress in overall production technology and scientific innovation, while the crests are the boom periods and troughs are the bust periods.
Causes and Impact of Boom and Bust Cycle
#1 – Money Supply
- This is the most important factor which leads to the cyclical behavior of GDP. Lower policy rate, and in turn lower lending rate of commercial banks, stimulates investment in the form of CAPEX in the economy. The production expands, employment and working hours increase, wages increase, consumption also increases.
- Such measures are taken by the central bank when the economy is under-performing and therefore it needs a boost, continued expansion causes a boom in the economy for an extended period of time till the production exceeds the full employment level or the potential GDP level.
- This situation is called the overheating of the economy or a situation of excess supply. When there is not enough demand, the revenue generation reduces and this leads to non-repayment of borrowed money and an increase in NPA. This leads to the start of the bust cycle leading to the reverse trend.
#2 – Investor Confidence
- Investors pump in money before they expect a boom, at this time the investment is cheaper and they assess that the future boom cycle will bring in huge returns. So one of the leading indicators of a boom cycle is investor confidence and inflow of investment.
- However, when investors see that the investment will not be fruitful and therefore the returns will be lower than expected, they pull out money and seek safer investment, due to this a bust cycle emerges.
- Investors use a stock exchange as a barometer for their assessment, if it is rising over a continued period of time, their confidence is maintained, however any decline in the same that is an outcome of misplaced economic policies, undermine their confidence and pre-empting the future decline in returns, the investors pull out money.
#3 – Fiscal Intervention
- This is the government side of actions that lead to expansion or contraction in the economy.
- Taxation and Subsidy are the two most important tools that the government has at its disposal. Reduction in taxation or providing a tax holiday for a given period of time can induce expansion and providing utilities at subsidized rates can also encourage producers to undertake a higher level of production because the cost of production falls. The opposite measures are undertaken when the economy is overheating.
- There are many regulations that are liberalized by the government to attract foreign investment such as the FDI & FPI norms, Exchange rate policies, Repatriation laws, and so on. Auto-correction in the economy takes a lot of time, so fiscal or monetary intervention is required otherwise the economy may go into depression leading to immense dissatisfaction and geopolitical instability.
How to protect yourself from Boom and Bust Cycle?
Pre-empting boom and bust cycles is a very difficult task and therefore market timing is an important concept in the stock market trading domain. Most retail investors are not able to time properly as they are not aware of the actions of institutional investors. Therefore they may only be able to figure out when they start seeing a clear indication of the direction in which the economy is moving.
However, this doesn’t mean that retail investors can’t achieve good enough returns from the uptrends and save themselves from the downtrends. Retail and institutional investors alike can take the following steps to not lose capital in the cyclical change by undertaking the following steps:
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#1 – Diversification
It is always good to have some level of diversification in the investment portfolio and income portfolio. For example, a good mix of equity, bonds, commodities will protect the investor from high inflation periods or bust cycles and provide good returns during boom cycles. Investors who are heavily dependent in any one sector for their income, should not take on financial investments in that sector only so that their risks to that sector are diversified.
#2 – Savings
Maintaining a healthy level of savings in a retirement fund and for the bust, cycle periods is a good strategy because that can come in handy when the economy is not doing very well. Postponing consumption which is not needed immediately is a good strategy.
#3 – Hedging
It is always a safer strategy to forgo some of the profits by investing in hedging instruments such as derivatives which help the investors in controlling their losses in unforeseen events. In the case of a Boom market, the instruments expire out of the money and therefore only the cost of these instruments is a drag on the return.
Conclusion
Boom and Bust Cycle is a part of the economic framework and is unavoidable. Therefore it is best to stay aware of the changing economic scenario and taking necessary actions as the circumstances demand to minimize the loss during busts and maximize the gains during the boom. Tracking the Fiscal Policy and monetary policy could be a good start for staying aware and thereby staying ahead of dire circumstances or pre-empting profitable situations and modifying savings, investment, and consumption strategies accordingly.
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