Business and Stock Market Cycles
Updated December 19, 2020
Economists have certain ways of labeling the business cycle. The business cycle may be defined as the changes that occur to the real GDP because of alternating periods of expansion and contraction. The phases are:
- Recession: A decline in the real GDP that occurs for at least two or more quarters. Recessions feed on themselves. During a recession, business people spend less than they once did. Because sales are failing, businesses do what they can to reduce their spending. They lay off workers, buy less merchandise, and postpone plans to expand. When this happens, business suppliers do what they can to protect themselves. They too lay off workers and reduce spending. As workers earn less, they spend less, and business income and profits decline still more. Businesses spend even less than before and lay off still more workers. The economy continues to slide.
- Low Point, or Depression: State of the economy where there are large unemployment rates, a decline in annual income, and overproduction. The time at which the real GDP stops its decline and starts expanding; the lowest point. Sooner or later, the recession will reach the bottom of the business cycle. How long the cycle will remain at this low point varies from a matter of weeks to many months. During some depressions, such as the one in the 1930s, the low point has lasted for years.
- Expansion and Recovery: A period in which the real GDP grows; recovery from a recession. When business begins to improve a bit, firms will hire a few more workers and increase their orders of materials from their suppliers. Increased orders lead other firms to increase production and rehire workers. More employment leads to more consumer spending, further business activity, and still more jobs. Economists describe this upturn in the business cycle as a period of expansion and recovery.
- Peak: The point at which the real GDP stops increasing and begins its decline; the highest point. At the top, or peak, of the business cycle, business expansion ends its upward climb. Employment, consumer spending, and production hit their highest levels. A peak, like a depression, can last for a short or long period of time. When the peak lasts for a long time, we are in a period of prosperity. One of the dangers of peak periods is that of inflation. During periods of inflation, prices rise and the value of money declines. Inflation is more of a threat during peak periods because employment and earnings are at high levels. With more money in their pockets, people are willing to spend more than before. In this way, demand is increased and prices rise.
How do economists keep track of the business cycle?
For many years, economists have tried to understand why there are ups and downs in that nation's economy. They want to learn what can be done to prevent recessions and maintain prosperity. Therefore, they ask the following questions: (1) In what phase of the business cycle is our economy at the present time? (2) Where is the business cycle heading?
To date, economists believe that there are five causes of the business cycle.
The first cause is changes in capital expenditures. When the economy is strong, businesses have expectations of sales growth; they invest heavily in capital goods. After a while, businesses may decide that they have expanded to their limit, so they begin to pull back on their capital investments and cause an eventual recession.
The second cause of the business cycle is inventory adjustments. At the first sign of an economy reaching its peak, there are some businesses that cut back their inventories and then build them back up again at the first sign of a trough. Either action causes the real GDP to fluctuate. Innovation and imitation are the third causes of the business cycle. Innovations include new products, new inventions, or a new way of performing a task. When a business innovates, it often gains an edge on its competitors because its costs decrease or its sales increase. Whatever the case, profits increase and the business grows. If other business in the same industry want to keep up, they then copy what the innovator has done (imitation) or they come up with something better. Imitation companies usually invest heavily and an investment boom follows. Once the innovation spreads to another industry, the situation changes. Further investments are unnecessary and economic activity may slow.
The fourth cause of the business cycle are the credit and loan policies of commercial banking. When "easy money" policies are in effect, interest rates are low and loans are easy to get. They encourage the private sector to borrow and invest, thus stimulating the economy. Eventually the increased demand for loans causes the interest rates to rise, which discourage new borrowers. As borrowing and spending slow down, the level of economic activity declines. The economy keeps declining until interest rates fall and the business cycle begins over again.
The fifth and final cause of the business cycle if external shocks. Shocks such as increases in oil prices, wars, and international conflict, have the potential to either drive the economy up, or drive it down. The economy may benefit when a new supply of natural resources is discovered. Such was the case with Great Britain in the 1970's when an oil field was discovered off its coast in the North Sea. The British economy of course profited seeing that world oil prices were at an all time high, but the high prices hurt the United States at the same time.
Business Cycle Basics
By examining empirical evidence, the investor can attempt to create a framework for viewing present and future events as they unfold. There are two key questions the investor may want to ask:
1. Will the historic pattern hold, or will it be altered? To answer that, you'll need to ascertain whether the factors driving today's market are fundamentally unchanged, or whether the situation has evolved incrementally or even been radically changed.
2. Has the market already taken the anticipated future events into account? If the factors driving the industry are the traditional cyclical ones, the market usually will have taken them into account, because they are expected. If the factors represent a new element in the equation, then the market may not be expecting them and may not have adjusted accordingly.
Business cycle and relative stock performance
The chart below shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market.
Stocks in consumer non-cyclicals (food) and consumer growth industries (cosmetics, tobacco, beverages) tend to experience fairly steady demand and are less sensitive to changes in the business cycle. These stocks typically attract investors when the economic cycle or bull market has matured, or is in the early stages of contraction.
Consumer Cyclicals (durable & non-durable)
Stocks in this category include durables and non-durables that are sensitive to interest rates as well as the business cycle. Investors typically seek them out when the economy is in the late stages of contraction.
In general, stocks in this sector move similarly to consumer non-cyclicals. This sector is considered defensive, meaning companies in this sector are generally unaffected by economic fluctuations. The healthcare industry consists of pharmaceutical firms, HMOs, biotechnology firms and medical equipment suppliers. Pharmaceutical companies are affected by competitive market shares, the pace of FDA approvals, patent lives, and the strength of the R&D pipelines. Many biotechnology firms are still in the development stage with their fortunes largely determined by investor perceptions of the relative merits of their R&D pipelines. With future new financing likely to be more difficult to obtain than in the past, strategic alliances between major drug companies and biotech firms are expected to increase.
Stocks in housing-related industries tend to respond well to falling interest rates and are often targeted by investors in the mid to late stages of an economic contraction. Non-mortgage-dependent banks are generally driven by commercial and consumer loan growth, and tend to be favored by investors during the middle of the cycle.
Technology stocks can be cyclical to the degree that they depend on capital spending and business or consumer demand. However, they may also have long-term growth potential as technological products find broader applications and as new technologies are developed. Technology stocks are usually popular during early to mid stages of an economic expansion.
Profits of basic industries are driven by high utilization of capacity and strong market demand for products. Therefore, their stocks tend to be popular with investors late in an economic expansion. For basic material companies, the global economic picture and supply/demand equation also affect stock price movements.
Capital spending tends to increase midway through the business cycle, as the economy is heating up and higher demand for products leads companies to expand their production capacity. Demand in global export markets is key for agricultural equipment, industrial machinery, and machine tools.
Railroads and other surface carriers tend to react early to a pickup in the economy. Airlines are subject to cyclical fuel costs, usage versus capacity, and competitive pressures on airfares.
This category includes large integrated international companies, domestic exploration companies, and energy services companies. Each industry has its own dynamics, but ultimately all are driven by the supply and demand picture for energy worldwide. Political events have historically had a major impact on these industries. Stocks tend to be popular with investors late in the business cycle.
Electric companies have historically been very sensitive to interest rates because of the large debt financing costs they must incur in order to build their infrastructures. These stocks tend to perform well in an environment of declining interest rates. Telephone companies may offer attractive long-term growth opportunities, as they diversify and compete in recently deregulated telecommunications markets.
Precious metals and the stocks of companies that mine and process them can be affected by industrial and consumer demand, but the largest factor contributing to volatility in this category is generally inflationary pressure. Investors often flock to this category late in the expansion cycle.
Chart of the stock, bond and business cycle
Last update: December 19, 2020