What Is an Economic Cycle?
Economic cycles are recurring fluctuations of an economy, which are generally measured by the rise and fall of the real gross domestic product (GDP) of a nation.
The Four Stages of an Economic Cycle
An economic cycle consists of four stages: expansion, peak, contraction, and trough:
Source: investhandbook
The expansion is characterized by positive economic indicators: The GDP grows at a healthy rate. The unemployment rate remains low. Inflation reaches the 2 percent target. Debts get paid on time. Interest rates are getting low, while stocks and other investments continue to rise.
At some point, the economy reaches its peak, which is the second stage of the economic cycle. That’s when the expansion is at its maximum and can’t get any further. Inflation starts to get too high and central banks usually try to reduce it by increasing interest rates.
High interest rates make all kinds of debt more expensive, while it also attracts people to save their money in banks because of the increased risk-free return on their investment. Suddenly, everyone starts to consume less, which results in decreasing revenue for companies. The economy starts to slow down and shifts over into a contraction.
Economic growth decreases. The demand for products and services start declining. The unemployment rate rises. All those economic indicators continue to fall until the economy hits the bottom.
The trough is the fourth stage of the economic cycle, which is the lowest point it can get. Then, the whole cycle slowly starts to renew, beginning with the expansion once again.
How Long Do Economic Cycles Last?
According to the National Bureau of Economic Research (NBER) who measures the length of U.S. economic cycles, the average economic cycle has a length of more than three years since 1854. However, the length of economic cycles can vary a lot.
For instance, the peak to peak cycle from 1920-1921 lasted for only 17 months, while one of the longest lasting periods of economic growth of the business cycle from 1991-2001 lasted for a remarkable duration of 120 months.
In fact, the current economic cycle, which started in June 2009, has now been going for 10 years, which is presumably becoming the longest economic cycle in U.S. history.
It is definitely hard to say how long a nation will be able to sustain this constant economic growth. But people shouldn’t rely on the average length of a cycle, as the current economic cycle is already surpassing the average cycle in terms of duration by far.
The Government’s Role in Economic Cycles
The government and the central bank can influence the economic cycle in very specific ways and policies.
The central government has control over taxes and can spend enormous amounts of money. In order to boost the expansion of an economic cycle, they have the choice to spend more and cut taxes, which ultimately increases the amount of money for the consumer to spend.
Central banks can influence interest rates and print additional money. Therefore, they have control over the amount of money and credit within an economy.
Low interest rates motivate more people to borrow money and therefore spend more. Additionally, investors get enticed to rather shift their money from savings accounts to investments with a higher return like stocks, which increases capital for companies which also become more encouraged to borrow more money and expand their businesses
Consequently, the whole economy grows with the increased amount of money there is to spend.
On the other hand, when central banks raise interest rates, for instance, to tackle high inflation, the exact opposite occurs: All types of debt become more expensive. Interest rates on savings accounts suddenly look attractive again. Consumers and companies are unlikely to take on expensive debt and therefore spend less. As a result, economic strength decreases.
Both the central bank and central government have the objective of keeping the economy growing as consistently as possible. Target rates for many central banks are around 2-3% in GDP growth.
How Investors Can Take Advantage of the Economic Cycle
It is important for investors to understand which stage of the economic cycle they’re currently in. Stocks may look attractive with great performance in the past as companies progress through the growth of an expansion. It can be hard to not catch yourself jump on the train of optimism in order to not miss any further returns.
However, you should always keep in mind that an economic expansion can not last forever and chances of facing a severe loss will increase along with increased risk tolerance and rising cheerfulness.
You may have probably heard of the principle of successful investing: Buying low and selling high. Most companies will generally be overvalued state during the peak of an expansion, while many stocks and other investments become undervalued in times when the economic cycle reaches the bottom.
But it is easier said than done. Most investors still tend to buy overpriced assets as everyone tells them that the economy is doing great and everything is just fine. It’s also hard to find any other alternative investments besides stocks, as interest rates stay at a low level.
Buying great assets at a cheap price and selling them as soon as they get way too overvalued (and gotten everyone’s interest), is what differentiates a good investor from the average investor.
The first step is to find out in which stage we are right now within the economic cycle to take the proper actions at the right time. Note that you shouldn’t try to essentially time the market but rather adjust yourself to the current circumstances to have the odds in your favor.
This can, for example, be done by determining the real value of stocks and other asset classes and then adjusting the own portfolio with the proper asset allocation.
Stocks Behave Differently Within Economic Cycles
There are types of companies, which don’t correlate with economic fluctuations which are called defensive stocks. Companies, which are heavily sensitive to the business cycle are defined as cyclical stocks.
It is certainly less risky to buy defensive stocks in times when the economy is overheating and the stock market overvalued. In general, they tend to perform better than cyclical stocks whenever a recession occurs.
Examples for non-cyclical stocks are most businesses within the healthcare and utilities industry sector. People are still going to spend money on healthcare and essential utilities like water, electric and gas, even during a recession. That is why their revenue doesn’t get hit as much as cyclical stocks, which are dependent on the confidence of consumers.
However, defensive stocks will still be affected by an economic contraction, because nowadays they are part of most indices and managed funds. Passive investors are also going to pull their money out of funds and panic sell their ETFs as they get too scared of a severe loss on their investment.
Stock prices of established defensive companies will go down along with the market, simply because most investors are rather investing their money on everything than on individual businesses.
That being said, after a stock market downturn, many great companies usually drop in price and thus, smart investors will have many great opportunities to buy undervalued stocks and therefore, benefit from an economic contraction.
Conclusion
Economic cycles and their characteristics play an important role in many decisions that have to be made within an economy. Governments and companies have to be aware of the stages of the economic cycle in order to make decisions that fit both their current and future objectives the best.
Investors that are aware of the economic cycle and internal business cycles of companies will have a clear advantage over other investors. A general level of risk tolerance that is based on the awareness of current economic circumstances can definitely result in better long-term results.
