Economics. Double ugh! No, you aren’t required to understand “the inelasticity of demand aggregates” (thank heavens!) or “marginal utility” (say what?). But a working knowledge of basic economics is crucial (and I mean crucial) to your success and proficiency as a stock investor. The stock market and the economy are joined at the hip. The good (or bad) things that happen to one have a direct effect on the other.

Getting the hang of the basic concepts

Alas, many investors get lost on basic economic concepts (as do some socalled experts that you see on television). I owe my personal investing success to my status as a student of economics. Understanding basic economics helped me (and will help you) filter the financial news to separate relevant information from the irrelevant in order to make better investment decisions. Be aware of these important economic concepts:

Supply and demand: How can anyone possibly think about economics without thinking of the ageless concept of supply and demand? Supply and demand can be simply stated as the relationship between what’s available (the supply) and what people want and are willing to pay for (the demand). This equation is the main engine of economic activity and is extremely important for your stock investing analysis and decision-making process. I mean, do you really want to buy stock in a company that makes elephant-foot umbrella stands if you find out that the company has an oversupply and nobody wants to buy them anyway?

Cause and effect: If you pick up a prominent news report and read, “Companies in the table industry are expecting plummeting sales,” do you rush out and invest in companies that sell chairs or manufacture tablecloths? Considering cause and effect is an exercise in logical thinking, and believe you me, logic is a major component of sound economic thought.

When you read business news, play it out in your mind. What good (or bad) can logically be expected given a certain event or situation? If you’re looking for an effect (“I want a stock price that keeps increasing”), you also want to understand the cause. Here are some typical events that can cause a stock’s price to rise:

• Positive news reports about a company: The news may report that a company is enjoying success with increased sales or a new product.
• Positive news reports about a company’s industry: The media may be highlighting that the industry is poised to do well.
• Positive news reports about a company’s customers: Maybe your company is in industry A, but its customers are in industry B. If you see good news about industry B, that may be good news for your stock.
• Negative news reports about a company’s competitors: If they are in trouble, their customers may seek alternatives to buy from, including your company.

Economic effects from government actions: Political and governmental actions have economic consequences. As a matter of fact, nothing (and I mean nothing!) has a greater effect on investing and economics than government. Government actions usually manifest themselves as taxes, laws, or regulations. They also can take on a more ominous appearance, such as war or the threat of war. Government can willfully (or even accidentally) cause a company to go bankrupt, disrupt an entire industry, or even cause a depression. It controls the money supply, credit, and all public securities markets.

What happens to the elephant-foot, umbrella stand industry if the government passes a 50 percent sales tax for that industry? Such a sales tax certainly makes a product uneconomical and encourages consumers to seek alternatives to elephant-foot umbrella stands. It may even boost sales for the wastepaper basket industry.

The opposite can be true as well. What if the government passes a tax credit that encourages the use of solar power in homes and businesses? That obviously has a positive impact on industries that manufacture or sell solar power devices. Just don’t ask me what happens to solar-powered elephant-foot umbrella stands.

Gaining insight from past mistakes

Because most investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios. In the late 1990s, the United States experienced the greatest expansion of debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing. This activity hyperstimulated the stock market and caused stocks to rise 25 percent per year for five straight years. Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. This artificial stimulation by the Fed resulted in the following:

• More and more people depleted their savings. After all, why settle for 3 percent in the bank when you can get 25 percent in the stock market?
• More and more people bought on credit. If the economy is booming, why not buy now and pay later? Consumer credit hit record highs.
• More and more people borrowed against their homes. Why not borrow and get rich now? I can pay off my debt later.
• More and more companies sold more goods as consumers took more vacations and bought SUVs, electronics, and so on. Companies then borrowed to finance expansion, open new stores, and so on.
• More and more companies went public and offered stock to take advantage of more money that was flowing to the markets from banks and other financial institutions.

In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. However, companies had too much overhead, capacity, and debt because they expanded too eagerly. At this point, companies were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. Companies, to stay in business, had to do the logical thing — cut expenses. What is usually the biggest expense for companies? People! To stay in business, many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security.

As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell. The lessons from the 1990s are important ones for investors today:

• Stocks are not a replacement for savings accounts. Always have some money in the bank.
• Stocks should never occupy 100 percent of your investment funds.
• When anyone (including an expert) tells you that the economy will keep growing indefinitely, be skeptical and read diverse sources of information.
• If stocks do well in your portfolio, consider protecting your stocks (both your original investment and any gains) with stop-loss orders
• Keep debt and expenses to a minimum.
• Remember that if the economy is booming, a decline is sure to follow as the ebb and flow of the economy’s business cycle continues.