We refer to it by different names: boom and bust; expansion and contraction; growth
and recession; and the proverbial bull and bear. What we’re talking about is the
economic cycle, aka “business cycle.”
Economic cycles are the recurrent boom-and-bust phases that markets and economies
typically exhibit. Think of it like a wave:
Expanding from a trough,
Peaking at the crest,
Descending (“contracting”) from the high point, and
Hitting bottom and recovering, where the wave begins anew.
The image of the cycle is easy to imagine, but what actually happens in the economy
during its entire span? What causes economic cycles? And is it possible to position
your investments to take advantage of the different phases?
Key Points
The economic cycle generally comprises four phases: expansion, peak,
contraction, and recovery.
The duration of economic cycles varies, making the phases difficult to time.
Some sectors tend to outperform others during different phases of the cycle.
Four phases of an economic cycle
Although there are numerous theories explaining what causes economic cycles, most
generally agree on the four phases: expansion, peak, contraction, and recovery.
Phase 1: Expansion. During the expansion phase, interest rates are often on the low
side, making it easier for consumers and businesses to borrow money. The demand for
consumer goods is growing, and businesses begin ramping up production to meet
consumer demand. To increase production, businesses hire more workers or invest
capital to expand their physical infrastructure and operations. Generally,
corporate profits begin to rise along with stock prices. Gross domestic product
(GDP) also begins rising as the economy gets its “boom” cycle underway.
Phase 2: Peak. At this stage, the economy reaches a maximum rate of growth. As
consumer demand rises, there’s a point at which businesses may no longer be able to
ramp up production and supply to match the increasing demand. Some companies may
find it necessary to expand production capabilities, which entails more spending or
investment. Businesses may also begin experiencing a rise in production costs
(including wages), prompting some to transfer these costs over to the consumer via
higher prices.
Consequently, businesses may begin to see a “topping-off” in profits despite
charging higher prices. Other businesses will see decreasing profits due to higher
manufacturing (input) costs or higher wage demands. Overall, inflationary pressures
start to build up, or “bubble,” and the economy begins to overheat.
Typically, the Federal Reserve will hike interest rates to combat rising prices—
making it more expensive to borrow money—in an attempt to cool the economy.
Phase 3: Contraction. Then the economic contraction begins. In this stage,
corporate profits and consumer spending, particularly on discretionary (e.g.,
luxury) items, begins to fall. Stock values also decline as investors move their
investments to “safer” assets such as Treasury bonds and other fixed-income assets,
plus good ole cash. GDP contracts due to the decrease in spending. Production slows
to match falling demand. Employment and income can also decline as businesses
temporarily freeze hiring or resort to laying off workers. Overall, economic
activity slows, stocks enter a bear market, and a recession typically follows.
Sometimes a recession is mild, but other contractions—such as the Great Depression—
are particularly severe and long-lasting. In a depression, many businesses close up
shop for good.
If the economy looks to be suffering a severe contraction, the Federal Reserve
tends to lower interest rates so that consumers and businesses can borrow money on
the cheap for spending and investment. Lawmakers may tweak tax policy and/or call
on the Treasury Department to issue economic stimulus in order to stoke consumer
spending and demand for goods and services.
Phase 4: Recovery. The recovery phase is when the economy hits its trough, bottoms
out, and begins the cycle anew. Policies enacted during the contraction phase begin
to bear fruit. Businesses that retrenched during the contraction begin to ramp up
again. Stock values tend to rise as investors see greater potential returns in
stocks than bonds. Production ramps up to meet rising consumer demand and with it,
business expansion, employment, income, and GDP.
