The business cycle refers to the ups and downs of an economy, moving between periods of growth (expansion) and decline (contraction).
Changes in the cycle can influence many things, like stock prices and interest rates, and so they can have a big impact on investor sentiment. Understanding the cycle can help you make better investment decisions.
What is a business cycle?
A business cycle has 4 main phases, namely expansion, peak, contraction, and trough. These stages mark the changes in economic activity, whether it’s ramping up or slowing down.
Analysts and investors look at different indicators to try to identify the phase that an economy is in or predict what comes next. These signals include employment data, inflation rates, and growth in the gross domestic product (GDP).
Though there are indicators, it can be near impossible to accurately predict when each phase will begin or how long it will last.
Each stage can sometimes last for months or even years, and the length of an entire cycle may also vary.
What happens during each phase of the business cycle?
1. Expansion
This is when the economy is growing. In general, businesses are doing well, unemployment is low, and people are spending more – even on discretionary or non-essential products and services.
How it may affect investors:
When people have more disposable income, businesses tend to make more money. Certain companies and sectors tend to be cyclical, which means they’re more heavily affected by changes in the cycle.
Cyclical sectors like retail, real estate, construction, and manufacturing tend to boom when the economy is doing well. Their profits may increase, boosting investor confidence and driving up share prices.
As consumer spending ramps up, inflation rates tend to rise faster. The government, specifically the central bank, may respond to growing inflation by increasing interest rates.
When interest rates are raised to keep inflation in check, newer bonds become more attractive. This can drive down demand for older bonds.
2. Peak
This is the highest point of economic growth and it marks the end of the expansion phase.
How it may affect investors:
At the height of economic growth, certain stocks may be overvalued, which means their prices are higher than what they’re truly worth.
This can lead to corrections, or when prices drop to reflect the “real” value of the affected assets. After reaching the highest point, economic activity starts to decline, and contraction begins.
3. Contraction
This is when economic growth slows down. Consumer demand drops and unemployment rises as companies take protective measures like cutting down on spending.
How it may affect investors:
Cyclical sectors tend to see lower profits as economic activity declines. As a result, investor confidence in the affected companies may drop.
Meanwhile, there are also sectors that continue to see demand no matter the economic conditions, like healthcare and utilities. Corporations in such industries are typically the ones with defensive stocks which may remain stable amid downturns.
A prolonged contraction may lead to a recession, but this isn’t sure to happen. Fear of a recession – even if it hasn’t actually happened yet – can cause investors to seek safety.
They may move their money out of high-risk investments like stocks and into products that they believe are safer.
4. Trough
As the economy contracts, it eventually reaches its lowest point before recovery begins and a new cycle starts with expansion.
How it may affect investors:
To stimulate economic growth during a contraction, policymakers may reduce interest rates. Expectations of a recovery may renew investor interest in stocks.
When prices drop to record lows, people tend to take advantage of the opportunity to buy low and sell high. Before you do so, remember that there’s no certainty that the economy, and asset prices, will recover right away.
The risks and opportunities presented by each phase serve as a reminder that it’s good to diversify your portfolio.
Being patient and keeping a long-term perspective can also help you ride the waves and navigate both good times and bad.
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