Economic and Market Cycles

Understanding business cycles is essential for CFP exam success and practical financial planning. The economy moves through predictable phases, and recognizing these patterns helps planners position client portfolios appropriately and set realistic expectations.

The Four Phases of the Business Cycle

The business cycle describes the recurring pattern of expansion and contraction in economic activity. Each cycle contains four distinct phases:

1. Expansion (Recovery)

Expansion is the growth phase characterized by:

• Rising GDP and economic output
• Increasing employment and job creation
• Growing consumer and business confidence
• Moderate inflation beginning to emerge
• Rising corporate profits and stock prices

During expansion, the economy is producing below its potential capacity initially, then gradually approaches full employment. The U.S. experienced an 11-year expansion from 2009 to 2020--one of the longest in history.

2. Peak

Peak represents the cycle's highest point, characterized by:

• Maximum economic output and capacity utilization
• Full employment (or beyond--unemployment below natural rate)
• Rising inflationary pressures
• High consumer confidence and spending
• Potential asset bubbles forming

At the peak, the economy is operating at or above its sustainable capacity. This phase often signals that a contraction is approaching.

3. Contraction (Recession)

Contraction is the decline phase characterized by:

• Falling GDP (two consecutive quarters of negative growth = technical recession)
• Rising unemployment
• Declining consumer and business confidence
• Falling corporate profits and stock prices
• Deflationary or disinflationary pressures

The National Bureau of Economic Research (NBER) officially dates U.S. recessions based on multiple factors beyond just GDP decline.

4. Trough

Trough marks the cycle's lowest point, characterized by:

• Minimum economic activity
• Highest unemployment
• Low consumer confidence
• Maximum pessimism in markets
• Foundations being laid for recovery

The trough is the launchpad for the next expansion. While clients may feel discouraged at this point, history shows recovery will occur.

Economic Indicators

Economic indicators help identify where we are in the business cycle. They fall into three categories based on their timing relative to economic changes.

Leading Indicators (Predict Future Activity)

Leading indicators change direction before the overall economy, typically 6-12 months in advance. They help forecast turning points.

Key Leading Indicators:

• Stock market indices (S&P 500) - Markets are forward-looking
• Building permits & housing starts - Construction signals future activity
• New orders for capital goods - Business investment intentions
• Average weekly hours (manufacturing) - Companies adjust hours before hiring/firing
• Initial jobless claims - Early warning of labor market changes
• Consumer expectations index - Future spending intentions
• Yield curve spread - Most reliable recession predictor
• Money supply (M2) - Monetary conditions affecting future growth

Coincident Indicators (Move with the Economy)

Coincident indicators change at approximately the same time as the overall economy. They confirm the current economic phase.

Key Coincident Indicators:

• Nonfarm payrolls - Most closely watched employment measure
• Real personal income (less transfer payments) - Current earnings
• Industrial production index - Current manufacturing output
• Real retail sales - Current consumer spending

Lagging Indicators (Confirm After the Fact)

Lagging indicators change direction after the economy has already shifted. They confirm trends that have already occurred.

Key Lagging Indicators:

• Unemployment rate - Companies are slow to hire and fire
• Consumer Price Index (CPI) - Inflation responds slowly
• Average prime rate - Banks adjust rates after economic shifts
• Average duration of unemployment - Job market confirmation
• Inventory-to-sales ratio - Adjusts post-cycle
• Commercial and industrial loans - Lending follows economic conditions
• Labor cost per unit of output - Productivity measure

The Yield Curve as a Recession Predictor

The yield curve plots interest rates of bonds with equal credit quality but different maturities. Its shape provides crucial information about economic expectations.

Yield Curve Shapes

Normal (Upward Sloping)

• Long-term rates > short-term rates
• Indicates healthy economic expectations
• Investors demand higher yields for longer-term risk

Flat

• Long-term rates approximately equal to short-term rates
• Signals uncertainty or transition
• Often precedes inversion or steepening

Inverted (Downward Sloping)

• Short-term rates > long-term rates
• Strong recession predictor
• Indicates market expects rates to fall (Fed cutting due to weakness)

Yield Curve Inversion Track Record

Since 1960, the spread between 3-month and 10-year Treasury yields has inverted before every U.S. recession. Only twice did an inversion not lead to recession: 1966 and the prolonged 2022-2024 inversion (the longest in 45 years at 26 consecutive months), which as of early 2026 has resulted in a "soft landing" rather than recession.

Key Exam Points:

• Average lead time: 12-24 months before recession begins
• The curve often "un-inverts" (normalizes) about 6 months before recession starts
• Watch the 2-year/10-year spread and 3-month/10-year spread

Yield Curve Theories

Three theories explain why the yield curve takes different shapes:

1. Liquidity Preference Theory - Investors prefer liquidity and accept lower short-term yields
2. Market Segmentation Theory - Different investors operate in different maturity segments; supply/demand determines rates
3. Expectations Theory - The curve reflects expected future short-term rates based on inflation expectations

Sector Rotation Strategy

Sector rotation involves shifting portfolio allocations among market sectors based on the current phase of the business cycle. Different sectors outperform at different phases.

Sectors by Business Cycle Phase

Cyclical vs. Defensive Sectors

Cyclical Sectors - Performance tied closely to economic conditions:

• Consumer Discretionary (retail, autos, entertainment)
• Financials (banks, insurance, capital markets)
• Industrials (manufacturing, transportation)
• Technology (hardware, software, semiconductors)
• Materials (chemicals, metals, paper)
• Energy (oil & gas exploration, equipment)

Defensive Sectors - Relatively stable regardless of economy:

• Consumer Staples (food, beverages, household products)
• Healthcare (pharmaceuticals, medical devices, services)
• Utilities (electric, gas, water)
• Real Estate (REITs often behave defensively)
• Communication Services (mixed cyclical/defensive)

Practical Application

Early Cycle Strategy:

• Overweight financials (loan growth, improving credit)
• Overweight consumer discretionary (pent-up demand)
• Underweight utilities and consumer staples

Late Cycle Strategy:

• Reduce cyclical exposure
• Increase defensive allocation
• Consider quality over growth

Contraction Strategy:

• Overweight defensive sectors
• Focus on dividend-paying stocks
• Maintain adequate cash/liquidity

Sector Rotation Limitations

• Timing is difficult - Markets anticipate cycles 3-6 months ahead
• Cycles vary in length - No two cycles are identical
• Transaction costs - Frequent rotation increases costs
• Tax implications - Short-term gains taxed at ordinary rates