A “business cycle” refers to the periodic expansion and contraction of a nation’s economy. Also known as an “economic cycle,” it tracks the different stages of growth and decline in a country’s gross domestic product, or economic activity.
Investors can pay attention to these fluctuations in the business cycle and time their investments accordingly. This type of investing is known as business cycle investing.
With this strategy, investors typically adjust their exposure to various sectors with stocks or bonds in their portfolios. Some industries outperform during periods of economic expansions, while others do better during contractions.
Business-cycle investing is not an exact science and past performance isn’t indicative of future returns. But historically certain industries have prospered during each stage of the business cycle. Here’s a rundown of the different business-cycle stages and which industries have been more favorable to invest in during each phase.
Things to Know About Business Cycles
Worker productivity, population growth and technological innovations are all factors that can contribute to whether an economy is going through a period of boom or bust. Such elements play a role into how many goods and services a nation’s businesses produce and how much its consumers are purchasing.
Other factors can also influence the economy, such as wars, pandemics, natural disasters, and political instability. These can cause a recession to happen sooner or otherwise shift the economic environment of a nation or the world.
In the U.S., the National Bureau of Economic Research (NBER) announces whether the economy is in a recession, or a new iteration of the business cycle. The government and central banks attempt to manage the business cycle by adjusting fiscal and monetary policies such as interest rates and taxes, or by launching federal projects or stimulus packages.
Although some people refer to business cycles and market cycles interchangeably, the latter refers specifically to the cycle of the stock market. Not all companies in an economy are public and have shares in the stock market. Meanwhile, the business cycle measures the entire economy. Although the two can be correlated, they aren’t the same.
Stages of the Business Life Cycle
There are four stages of the business cycle, which fall into two phases: a growth phase of expansion and a declining phase of contraction. Each full cycle can last anywhere from one year to 10 or more years. Since 1945, there have been 11 business cycles . Each business cycle is dated from peak to peak or trough to trough of economic activity.
During the expansion phase of the business cycle, GDP increases and the economy grows. This phase tends to be significantly longer than the contraction phase. Since 1945, the average expansion has been 65 months, while the average contraction has lasted 11 months, according to a congressional research report. Features of expansion periods include:
• GDP growth rate of 2-3%
• Inflation around 2%
• Unemployment between 3.5-4.5%
• Bullish stock market
• Increased demand for goods and services
• Interest rates move higher
• Job creation
• Stock prices usually increase
• Increased wages
• Increased real estate values
As economic growth slows down, an economic contraction begins as the nation enters a recession. GDP growth dips below 2% in this phase.
Companies that have taken out loans may struggle to repay them, so they have to lay off workers and slow down production. As workers lose jobs, they have to cut down on spending. This creates a cycle of economic decline. Features of contraction periods include:
• GDP growth falls below 2%
• Decreased demand for goods and services
• Interest rates move lower, making it easier to borrow money
• Loss of jobs, increased unemployment
• Reduced wages because people need jobs so they’re willing to work for less, and companies can’t pay as much
• Stock prices usually decline
• Real estate values plateau or decline
Stage 1: Recession
One definition of a recession is two consecutive quarters with a decline in real GDP. A recession could actually be defined more broadly as a period where there is significant decline in economic activity throughout the entire economy.
During this stage, GDP, profits, sales, and economic activity decline. Credit is tight for both consumers and businesses due to the policies set during the last business cycle. This leads to shifts in monetary policy that lead to a recovery phase. It’s a vicious cycle of falling production, falling incomes, falling employment, and falling GDP.
The intensity of a recession is measured by looking at the three D’s:
• Depth: The measure of peak to trough decline in sales, income, employment, and output. The trough is the lowest point the GDP reaches during a cycle. Before World War II, recessions used to be much deeper than they are now.
• Diffusion: How far the recession spreads across industries, regions, and activities.
• Duration: The amount of time between the peak and the trough.
A more severe recession is called a depression. Depressions have deeper troughs and last longer than recessions. The only depression that has happened thus far was the Great Depression, which lasted 3.5 years, beginning in 1929.
Stage 2: Early Cycle
Following a recession, there tends to be a sharp recovery as growth begins to accelerate. The stock market tends to rise the most during this stage, which generally lasts about one year. Interest rates are low, so businesses and consumers can borrow more money for growth and investment. GDP begins to increase.
Just as a recession is a vicious cycle, a recovery is a virtuous cycle of rising income, rising employment, rising GDP, and rising production. And similar to the three D’s, a recovery period, which includes Stages 2-4, is measured using three P’s: how pronounced, pervasive, and persistent the expansion is.
Stage 3: Mid-Cycle
This is generally the longest phase of the business cycle, with moderate growth throughout. On average the mid-cycle phase lasts three years. Monetary policies shift toward a neutral state: Interest rates are higher, credit is strong, and companies are profitable.
Stage 4: Late Cycle
At this stage, economic activity reaches its highest point, and while growth continues, its pace decelerates. Monetary policies become tight due to rising inflation and low unemployment, making it harder for people to borrow money. The GDP rate begins to plateau or slow.
Companies may be engaging in reckless expansions, and investors are overconfident, which increases the price of assets beyond their actual value. Late cycles last a year and a half on average.
What Industries Do Well During Each Stage?
Historically certain industries have prospered during each stage of the business cycle.
When money is tight and people are concerned about the economy, they cut back on certain types of purchases, such as vacations and fancy clothes. Also, when people anticipate a coming recession, they tend to sell stocks and move into safer assets, causing the market to decline.
Basically, industries do better or worse depending on supply and demand, and the demand for certain products shifts throughout the business cycle. In general, the following industries perform well during each stage of the business cycle:
• Consumer staples
• Information technology
• Financial sector
• Industrial sector
• Consumer sector
• Stocks and bonds
• Real Estate
• Household durables
• Information technology
• Energy and materials
• Commodities such as oil and gas
• Bonds can be a safe haven
• Index funds
Who Should Invest With the Business Cycle?
Business cycle investing is an intermediate-term strategy, since it isn’t as short-term as day trading but not as long-term as buy and hold strategies. Each stage of the business cycle can last for a few months to a few years.
Some investors prefer a long-term buy-and-hold strategy, in which they don’t try to time the market and make few changes to their portfolio. This is generally the best strategy for beginner investors.
However, more experienced investors might choose to shift at least a portion of their portfolio along with the business cycle. Business cycle investing can also be a good option for younger investors because they will have more opportunities to take advantage of the ups and downs of future cycles.
Understanding the business cycle can also help people make decisions such as when to buy a home or search for a job. It’s usually best to purchase a home, start a business, or look for a job in the early to mid-stages of the cycle.
No business cycle is identical but history shows there can be a rough pattern to which industries do better as the economy expands and contracts. Investors can take cues from which stage of the business cycle the economy is in in order to allocate money to different sectors.
One great way to invest and keep track of the market is using an online investing app like SoFi Invest®. The investing platform features both active and automated investing.
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