All capitalist economies in the world experience periodic swings in their economic activity. In some years, a nation’s economy will be growing, and the output of goods and services increases. In other years, the economy will show a downward trend when output declines and unemployment rises. These ups and downs of an economy are called business cycles or economic cycles. The length of a single business cycle is the period of time containing a single expansion and contraction in sequence.
Business cycles are used to analyze the state of the economy. Thus, insight into economic cycles can be beneficial for both businesses and investors.
This article will explain what business cycles are, their causes, how they are measured, how the government can influence them, and how they affect investment decisions.
What Is a Business Cycle?
The business cycle, also known as the economic cycle or trade cycle, is defined as the series of fluctuations found in a nation’s economic activity around its long-term growth trend.
One business cycle includes the completion of an expansion phase and a contraction phase sequentially. The economy is prospering and growing during the expansion phase until it reaches its highest point or peak. During the contraction phase, the economy starts its decline until it reaches its lowest point or trough.
Business cycles are measured from peak to peak or from trough to trough. In the U.S, business cycles are measured, and the business cycles’ turning points (peaks and troughs) are dated by the National Bureau of Economic Research (NBER). The NBER views real Gross Domestic Product (GDP) as the best measure of aggregate economic activity. However, it also considers other macroeconomic indicators such as industrial production, employment, real income, and retail sales.
The name “business cycles” implies that they occur regularly at similar intervals and are therefore predictable. However, these fluctuations in economic activity are the opposite. They seem to be unpredictable, irregular, and of various lengths.
All capitalist economies experience these business cycles, but they don’t occur simultaneously in every country. However, due to increased globalization, business cycles are more likely to happen simultaneously in different countries than ever before.
Fluctuations in economic activity are attributable to various external and internal causes. Numerous factors considerably influence the business cycle. These factors include technological improvements, fiscal policy, monetary policy, demographic shifts, oil price spikes, wars, pandemics, and more.
Phases of the Business Cycle
The business cycle is defined as a period of expansion and subsequential contraction around its long-term growth trend. The trend line shows that the economy is always moving upwards or growing in the long run. The business cycle consists of four identifiable phases; expansion, peak, contraction, and trough.
Please note that although each of the phases has its own characteristics, sometimes short-term reversals in economic activity may occur in both the expansion and contraction phases. For example, a contraction phase may include a short-term economic growth period followed by a further contraction. In contrast, an expansion phase may include a short-term economic decline followed by further expansion. However, over more extended periods of time, the business cycle’s volatility fades to reveal a pattern of expansion or contraction of the economy.
Also, keep in mind that the rate at which the economy is expanding or contracting can vary significantly over time during a single business cycle. For example, during the 2009-2020 expansion phase, real GDP grew at an average rate of about 2.3% per year. At the same time, real GDP shrank at an annual rate of 5.0% in the first quarter of 2020 and 32.9% in the second quarter.
An expansion is the period from a trough to a peak. The expansion phase is considered the most desirable phase of the business cycle. During this phase, the economy is growing at a steady pace. The expansion phase is the “normal” state of the economy. The GDP growth rate is healthy, and between 2 and 3%, the unemployment rate is “normal” and between 3.5 and 4.5%, and Inflation is near its 2% target.
During this phase, companies are growing, and so are industrial production and profits. At the same time, unemployment remains low, and wages start increasing. As a result, GDP and retail sales are rising as well. Furthermore, consumer confidence is up, and consumers are buying and investing. Due to increased demand, prices and investments are booming.
According to the National Bureau of Economic Research (NBER), the longest expansion phase on record is the most recent one that started in June 2009 and lasted until February 2020. This was when the COVID-19 pandemic halted the expansion phase. This expansion phase lasted 128 months. The previous longest growth phase was 120 months and occurred between March 1991 and March 2001. Expansion phases this long are uncommon. For example, between 1945 and 2020, the average expansion phase in the US lasted about 64 months.
At some point, the economy starts overheating and growing out of control. The GDP growth rate is way higher than the healthy 3%, inflation is higher than 2% and still rising, companies keep increasing production, and consumers have become overconfident. As a result, prices are rising out of control, and economic indicators show no more growth in the future. Economic growth has reached its limits, its peak. It is the highest point of the business cycle.
The peak indicates a turning point. Then, the expansion phase ends, economic growth begins reversing, and the contraction phase starts. According to the NBER, the most recent peak occurred in February 2020.
3. Contraction (Recession)
The contracting phase starts at the peak and ends at the trough. After the peak, when demand starts falling in certain segments of the economy, the business cycle’s contraction phase begins. Economic growth slows down, and GDP falls below the desired 2%. When GDP turns negative, it is called a recession. Businesses stop hiring, cut costs, and unemployment levels start rising. This results in a decline in household spending. Prices start falling, and inflation might even turn negative (deflation). Investors start selling, and the stock market becomes a bear market. This decline becomes a vicious cycle.
A recession used to be defined as two consecutive quarters of a decline in real GDP. However, NBER’s Business Cycle Dating Committee now considers a recession to be “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
On June 8th, 2020, the NBER stated that the worst U.S. downturn since the Great Depression had turned into a recession. It announced that “the pandemic and the public health response have resulted in a downturn with different characteristics and dynamics than prior recessions.” In addition, they stated that “the unprecedented magnitude of the decline in employment and production, and its broad reach across the entire economy, warrants the designation of this episode as a recession, even if it turns out to be briefer than earlier contractions.”
U.S. GDP fell 5% in the first quarter and contracted a record 31.4% in the second quarter of 2020. The recession started because of the Covid 19 pandemic resulting in the shutdown of 95% of the U.S. economy. In April of 2020, the unemployment rate increased to 14.7%, the worst in post-World War II history. In addition, and U.S. retail sales plummeted 16.4%. Uncertainty over the pandemic’s impact on the economy caused the March 2020 stock market crash and started a new bear market.
According to the NBER, the most recent peak occurred in February 2020, and the most recent trough occurred in April 2020. So, officially the Covid recession lasted only two months, making it the shortest US recession on record.
Luckily, the economy started improving during the latter part of 2020. This was due to government stimulus that provided financial aid to families and businesses and the Federal Reserve lowering the fed funds rate to 0%. NBER reported that the economy grew 33.1% in the third quarter and 4% in the 4th quarter of 2020, and the most recent peak occurred in February 2020. Unfortunately, this was not enough to make up for earlier losses.
Typically, most contractions are brief. Between 1945 and 2020, the average length of a U.S. contraction had been about 11 months. However, the latest recession was only 2 months long.
Just as the peak denotes the highest point of a business cycle, the trough indicates the lowest point. A trough occurs when the contraction or recession hits rock bottom. Unemployment keeps increasing, wages fall, and there is depletion of national income. Prices fall, and eventually, the low costs create opportunities to start new businesses. These businesses then hire people, resulting in more discretionary income and increased consumer spending and investing. Prices start rising again, and the economy slowly starts expanding again. Another period of growth with corresponding expansion follows, and a new business cycle starts again with the expansion phase.
The most recent trough occurred in April 2020.
Measuring and Dating Business Cycles
Economy-wide trends can have a significant impact on everyone, especially on businesses and investors. Understanding what happens in the different phases of the business cycle is critical when preparing for them. Predicting when the next stage of the business cycle will start is difficult. However, being prepared when it happens is important because it will affect a company’s profitability, long-term survival, and success. For investors, this is equally important, as changes in the business cycle’s growth pattern create investment opportunities. These changes affect which asset classes and stock sectors will most likely start underperforming and which ones will start outperforming the broad market.
The National Bureau of Economic Research (NBER) is a private, non-profit, independent research institution that measures and publishes fluctuations in the U.S. economy. It defines the point at which the economy enters the different phases of the business cycle. In addition, their National Bureau’s Business Cycle Dating Committee maintains a chronology of U.S. business cycles. It identifies the dates of the peaks and troughs that frame economic expansions and recessions.
Economic data is collected after the fact. Thus, to be precise and avoid making changes to its published data, it can easily take the NBER up to a year after the economy starts growing again to announce that a recession has officially ended.
On July 19th, 2021, the NBER officially announced that a trough in monthly economic activity occurred in the US economy in April 2020. This indicates the end of the 2020 recession. It also means that May 2020 marks the beginning of a new expansion phase officially.
Since 1854, the NBER has identified more than 30 defined business cycles in the United States. As mentioned before, real GDP is not the only metric the NBER considers in determining the dates of peaks and troughs. However, it is the most important one. They also consider other indicators in their date determination, because GDP does not always pick up on a weakening economy. Factors like Real Gross Domestic Income (GDI), unemployment rates, industrial production, and wage growth, are also taken into consideration.
Length of a Business Cycle
Not even economists, can predict when exactly the different phases of the business cycle will occur, how long each stage will be, and what exactly will cause the next business cycle. Therefore, there is no definite time frame for business cycles. It can last from a few months up to many years. The length of a business cycle is the period of time it takes to complete a single boom and contraction.
Though generally, expansion phases last longer than contraction phases, each business cycle’s total length varies. Since World War II, in the United States, the average length of the expansion phase has been about 64 months. In contrast, the average length of the contraction phase has only been about 10 months.
The US economy recently experienced a peak phase in February of 2020. This was after the longest expansion phase on record that lasted for 128 months. This expansion phase started in June of 2009 and ended in February 2020 due to the Covid 19 pandemic’s economic downturn. The length of this expansion phase was unusual.
What Causes Business Cycles?
Most economists believe that expansions and contractions in the business cycle occur at irregular intervals, vary in length, and are difficult to predict. The forces of aggregate demand and supply cause the movement in the economy’s GDP and generally cause business cycles. However, a combination of factors often triggers the different phases of a business cycle.
There are endogenous causes (internal) factors within the economy that may be causing these changes. In addition, there are also external factors that may lead to the boom or contraction of an economy.
Here are some of the primary causes of business cycles:
- Consumer confidence
- Fluctuations in capital investment
- Monetary policy (interest rates)
- Fiscal policy (government spending and taxes)
- multiplier effect
- Wars and political unrest
- Technological shocks and breakthroughs
- Natural disasters such as floods and hurricanes
- Trade barriers
Business Cycle versus Market Cycle
The business cycle is often confused with the market cycle though they are different. Market cycles refer to the stock market’s growth and decline, while business cycles reflect the ups and downs of an economy. Another difference is that a market cycle is measured based on stock market indexes such as the S&P 500.. Business cycles, on the other hand, are measured based on real GDP and other indicators such as unemployment and real GDI. However, the two cycles are related to a great extent and affect each other greatly.
On the one hand, the stock market is often seen as a leading indicator. Many people look at the stock market to see where the economy is going. The S&P 500 value is based on investors’ and analysts’ expectations of the stock market’s future earnings and growth. For instance, a rising S&P 500 index typically means that growth is in the forecast, and the entire economy will flourish. Conversely, a downward market might mean a decrease in expected growth and a recession in the economy.
However, please note that the stock market is not a perfect leading economic indicator. Stock prices are often based on a company’s perceived value, and not their true value (intrinsic value). This can easily result in overvalued or undervalued stocks . The DOTCOM bubble in the late 90s is a perfect example of this. Many tech companies’ stock prices kept rising for years, which created a false sense of optimism for the economy. Unfortunately, these stock prices were way overvalued, and in 2001, the bubble burst, and the stock market crashed. The crash happened because investors ignored other economic indicators. As a result, the U.S. economy started a recession in March of 2001.
The business cycle also influences the stock market cycle and its stages. During an economic contraction phase, investors might want to decrease their stock exposure and buy safer investments such as bonds. Or, maybe, they want to completely abandon the market. Stock sell-offs are common in a down economy, often resulting in a bear market. In contrast, during an economic expansion phase, investors start buying more stocks. As a result, stock prices increase and a bull market will start..
Moving into a different business cycle phase can also create some new investment opportunities. It is well-known that some industries and sectors perform better in certain phases of the economic cycle than in others. For example, counter-cyclical sectors such as discount retailers, fast food, and sin stocks tend to do well during a recession. So, by paying attention to which phase of the economic cycle we are in, active investors can take advantage of opportunities using sector rotation.
Another way for traders and investors to make money during a recession is by short-selling stocks. Shorting a stock is based on the prediction that stock prices will go down rather than up. This is often the case during a recession. However, short-selling is a high-risk strategy that only professionals should follow. Short-sellers borrow stocks from their broke r and then sell those stocks at the current market price, which they believe is high and will go down. Then, when the market price of those stocks has dropped enough, they will repurchase the stocks at a lower price and return them to their broker. This is how they make a profit.
In contrast, portfolio and hedge fund managers will use this strategy to hedge or protect a long position’s downside risk in another security during a decline in the stock market. This is possible because the fund can sell the stock when it’s high and buy when it’s low.
Value investors can also benefit from a recession. They actively look for stocks that have significantly dropped in price temporarily but are perceived to be undervalued and are expected to rise again. In other words, value investors take advantage of bear markets to pick up high-quality companies at bargain prices.
Although recessions usually have a large negative impact on consumer and investor confidence, long-term investors that use the buy-and-hold strategy do not pay much attention to recessions. This is because they know that recessions are usually short and that they will have little effect on their 20-to-30 year investment horizon.
How Government Can Influence Business Cycles
Though each business cycle goes through its 4 phases, and each phase seems unpredictable, it does not mean that some of the phases cannot be influenced or managed to some extend. For example, many countries try and influence various phases using government policies to either speed up the contraction phase or slow down the expansion phase.
The U.S. government has 2 tools to do this, fiscal policy implemented by the government and monetary policy executed by the Federal Reserve, the U.S. Central Bank.
Fiscal policy is based on Keynesian economics. Keynesians believe that government intervention can stabilize economic fluctuations and the business cycle by using government spending and tax policies. During a recession, especially at the trough of the business cycle, the government is usually quick to implement expansionary monetary policy by increasing government spending or offering tax cuts to consumers and businesses. This will increase employment, wages and boost demand, resulting in economic growth.
However, governments are usually reluctant to introduce contractionary fiscal policies such as tax increases and government spending cuts when the economy starts overheating. Although this will reduce disposable income, resulting in a slowdown in economic activity, politicians continue to ignore fiscal policy in an overheated economy because they are afraid they will not get re-elected when they raise taxes or cut spending.
The best example of the use of fiscal policy by the Federal Reserve Bank was its response to the Covid 19 pandemic. On March 15, 2020, the Fed lowered the fed funds rate to 0%, and reduced the banks’ reserve requirements to zero. As a result, banks could now lend 100% of their deposits. In September 2020, the Federal Reserve promised to keep the fed funds rate at 0% until 2023.
The Federal Reserve Bank’s monetary policy mandates promote stable prices (manage inflation), maximum employment, and moderate long-term interest rates.
When the economy is overheating, and inflation is rising, the Fed can use contractionary monetary policy by restricting the money supply and increasing interest rates. This will make loans more expensive, resulting in fewer consumers borrowing and slowing economic growth. Conversely, when the economy is weak, the Fed can increase the money supply and lower interest rates to spur economic growth.
The best example of the government’s monetary policy was its response to the Covid-19 pandemic in 2020. Early in the pandemic, Congress passed several acts to provide financial aid to families and businesses.
One of those acts, the biggest aid package in U.S. history, was the CARES Act (Coronavirus Aid, Relief, and Economic Security Act). This was a $2 trillion package including stimulus checks, expanded unemployment insurance, loans to states, local governments and businesses, and support for hospitals. Another aid package, the Paycheck Protection Program, and Health Care Enhancement Act, allocated $483.4 billion to small businesses, hospitals, and testing.
We all know that the U.S. economy periodically goes through periods of decline and prosperity and that recessions are inevitable. Although we realize that we cannot always predict when an economic downturn or an economic expansion will start, we must understand the different business cycle stages and be prepared for them.
Business cycles are an important consideration for consumers, businesses, investors, and governments alike because the different phases of each cycle greatly affect these groups’ behavior and spending patterns. Recessions are unnerving for everyone but with some careful planning, it is possible to get through them with as little financial damage as possible. Having an emergency fund in place and avoiding unnecessary expenses are good ways to prepare for a recession.
As an investor, the most important advice is not to panic and carefully consider whether it is smart to sell your investments. Remember, recessions are a natural part of the business cycle. Eventually, the economy will rebound again, stock prices will increase again, which means that your investments most likely will rebound as well. Thus, refraining from selling, focusing on a mid and long-term horizon, and understanding how certain sectors react to the different stages of the business cycle can even help you position your portfolio with securities or funds that have a strong probability of outperforming the rest of the market.
Business cycles help make spending and investment decisions. The key to surviving the business cycle’s difficult times is keeping track of where we are in the business cycle, avoiding panic, and building a diversified portfolio to maximize returns while reducing risks.