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All business cycles are positioned by a sustained period of economic growth, followed by a sustained period of economic decline. Throughout the life cycle, a business cycle goes through four identifiable stages, known as phases: expansion, peak, contraction and slump. This phase is considered to be the normal stage or at least the most desirable when the state of the economy is up.
During an expansion, businesses and companies are steadily growing their production and profits, unemployment remains low, and the stock market is performing well. Consumers are buying and investing, and with this increasing demand for goods and services, prices begin to increase too.
Once these numbers start to increase outside of their traditional ranges, though, then the economy is considered to be growing out of control. Companies may be expanding without thinking of the risks. Investors are overconfident, buying up assets and significantly increasing their prices, which are not supported by their underlying value. Everything starts to cost too much. The peak marks the climax of all this feverish activity. It occurs when the expansion has reached an end and indicates that production and prices have reached their limit.
A contraction extends the length of time from the peak to the slump. When the GDP has gone down for 2 consecutive quarters, the economy is often considered to be in a recession. It usually happens when the recession, or contraction phase, bottoms out and starts to rebound into an expansion phase and the business cycle starts all over again. The rebound is not always quick to occur, nor is it a straight line, along the way towards full economic recovery.
Understanding the business cycle is key for investors. The rebound is not always quick, nor is it a straight line, along the way toward full economic recovery. The most recent trough was in April Though often used interchangeably, a business cycle is technically different from a market cycle. A market cycle specifically refers to the different growth and decline stages of the stock market, while the business cycle reflects the economy as a whole.
But the two are definitely related. The stock market is greatly influenced by the phases of a business cycle and generally mirrors its stages. During the contractionary phase of a cycle, investors sell their holdings, depressing stock prices — a bear market.
In the expansionary phase, the opposite occurs: Investors go on a buying spree, causing stock prices to rise — a bull market. Business cycles have no defined time frames. A business cycle can be short, lasting a few months, or long, lasting several years. Generally, periods of expansion are more prolonged than periods of contraction, but the actual lengths can vary.
Since the end of World War II, the average period of expansion in the US lasted 65 months, and the average contraction lasted about 11 months, according to the Congressional Research Service. Most recently, the US hit a peak in February , and before that was in a period of expansion that had lasted roughly months, making it the longest in recorded history.
The many variables in an economy fluctuate differently over time, causing shifts in the economy, and non-economic factors, such as natural disasters and disease, play a part in shaping the economy as well. In recent history, the subprime mortgage crisis of was one such shock, and the onset of the COVID pandemic in was another creating a two-month recession.
From technological innovations to wars, a variety of things can shift a business cycle's phases. But, according to the Congressional Research Service, the key influence boils down to the aggregate supply and demand within an economy — economist-speak for the total spending that individuals and companies do. When that demand decreases, a contraction occurs.
Likewise, when demand increases, an expansion occurs. The fact that business cycles move in natural phases doesn't mean they can't be influenced. Countries can and do try to manage the various stages — slowing them down or speeding them up — using monetary policy and fiscal policy. Fiscal policy is carried out by the government; monetary policy is carried out by a nation's central bank. For example, when an economy is in a contraction, particularly a recession, governments use expansionary fiscal policy, which consists of increasing expenditures on government projects or cutting taxes.
These moves provide increased levels of disposable income that consumers can spend, which in turn stimulates economic growth. Similarly, a central bank — like the Federal Reserve in the US — will use an expansionary monetary policy to end a contractionary period by reducing interest rates, which makes borrowing money cheaper, thus stimulating spending, and eventually the economy.
If an economy is growing too fast, governments will employ a contractionary monetary policy , which involves cutting spending and increasing taxes. This reduces the amount of disposable income to spend, slowing things down. To employ a contractionary monetary policy , a central bank will increase interest rates, making borrowing more expensive and therefore spending money less attractive. Even though they seem like something that only affects "the economy," business cycles have plenty of real-world implications for individuals.
Recognizing the current cycle can influence people and their lifestyle decisions. For example, if we're in a contraction phase, finding work often becomes more difficult. Individuals may take up less-than-ideal jobs just to ensure they are making an income, and and hope for a better position once the economy improves. It may also influence spending, especially when making huge decisions like buying a home or a car. Understanding the business cycle is also crucial for investors. Knowing which assets — especially stocks — perform well in the different phases of a business cycle can help an investor avoid certain risks and even grow the value of their portfolio in a contractionary phase.
For example, certain industries remain crucial regardless of the current business cycle such as healthcare and energy. On the other hand, it may be best to stay away from speculative assets and high-risk stocks.
When making these investment decisions, it's a good idea to start by looking at a company's balance sheet , which will tell you a company's assets and liabilities. A strong balance sheet has more assets than liabilities, even when the market looks like it's headed into a contraction phase. Individuals can't do much on their own to affect a business cycle, and weathering its down phases can be tough.
Still, it might help you sleep better at night knowing "it's a cycle and that we won't be there forever," says Reinhart. Credit Cards Angle down icon An icon in the shape of an angle pointing down. Investing Angle down icon An icon in the shape of an angle pointing down.
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Business cycle investing is. investmenttradeexchange.com › learn › content › business-cycle-investing. While every business cycle is different, an approach to investment analysis that identifies key phases in the economy and looks at how.