Business Cycles

The economy doesn't grow in a straight line — it expands and contracts in recurring patterns called business cycles. Understanding these cycles helps explain market behavior and informs investment decisions.

What Is a Business Cycle?

A business cycle is the natural fluctuation in economic activity over time. Economies move through periods of growth, peak activity, decline, and recovery in a recurring pattern.

The Four Phases

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Expansion Phase

During expansion, the economy is growing:

Characteristics

• GDP increasing — Economic output rises
• Employment rising — Businesses hire more workers
• Consumer confidence high — People spend more freely
• Business investment growing — Companies expand capacity
• Credit available — Banks willing to lend

Market Behavior

• Stock prices generally rise
• Corporate earnings grow
• Interest rates may rise as demand for credit increases
• Cyclical sectors (industrials, consumer discretionary) outperform

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Peak Phase

The peak is the high point before the economy turns down:

Characteristics

• Maximum economic output — Economy at full capacity
• Full employment — Low unemployment
• Inflationary pressures — Demand exceeds supply
• Rising interest rates — Fed may tighten policy
• Overconfidence — Excessive optimism, speculation

Warning Signs

• Labor shortages
• Rising wages pushing up costs
• Asset bubbles forming
• Fed raising rates aggressively

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Contraction Phase

During contraction, economic activity declines:

Characteristics

• GDP falling — Economic output shrinks
• Unemployment rising — Layoffs increase
• Consumer spending drops — People save more, spend less
• Business investment falls — Companies cut back
• Credit tightens — Banks become cautious

Recession Defined

A recession is commonly defined as:

• Two consecutive quarters of negative GDP growth
• The National Bureau of Economic Research (NBER) officially declares recessions based on multiple factors

Market Behavior

• Stock prices generally fall
• Corporate earnings decline
• Interest rates typically fall
• Defensive sectors (utilities, consumer staples) outperform

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Trough Phase

The trough is the lowest point before recovery begins:

Characteristics

• Economic activity bottoms — Decline stops
• High unemployment — But layoffs slow
• Low consumer confidence — But stabilizing
• Interest rates at lows — Fed stimulating
• Value opportunities — Beaten-down assets

Signs of Recovery

• Unemployment claims dropping
• Consumer spending stabilizing
• Business orders increasing
• Credit conditions improving

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Economic Indicators

Economists track various indicators to gauge where we are in the cycle:

Leading Indicators

Predict where the economy is heading:

Coincident Indicators

Confirm current economic conditions:

Lagging Indicators

Confirm trends after they've occurred:

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Cyclical vs. Defensive Investments

Different sectors perform differently through the cycle:

Cyclical Sectors

Highly sensitive to economic conditions:

Defensive Sectors

Less sensitive to economic swings:

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Investment Strategies by Phase

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Historical Context

Average Cycle Length

• Expansions: Average ~5-6 years (but vary widely)
• Contractions: Average ~1 year
• Full cycle: Average ~6-7 years

Recent Cycles

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Key Takeaways

• Business cycles have four phases: expansion, peak, contraction, and trough
• Leading indicators predict future conditions; lagging indicators confirm past trends
• Cyclical sectors perform best in expansions; defensive sectors hold up better in contractions
• Recessions are generally defined as two consecutive quarters of negative GDP growth
• Understanding cycles helps with sector rotation and timing investment decisions
• No two cycles are identical — they vary in length, severity, and causes