The Business Cycle
Professional investors on Wall Street and other financial centers around the world view the market as having some type of pattern, which they call the business cycle. They observe that businesses (as reflected in the stock market) swing from good times to bad times in a fairly regular manner.
Four Sections of the Business Cycle
There are four major parts of the business cycle: maturation, contraction (or recession), revival, and expansion.The economy flows through the four sections of this business cycle, and the way this happens is worthy of an explanation.
Let’s say that we are at the stage of the business cycle where things are going great. The Dow and the S&P 500 are flying high. (In common business language, when the stock market is booming, investment experts refer to this as a bull market). Businesses can’t keep up with the demand for their products – they can’t supply enough for consumers. They have to borrow money to invest in more equipment to expand their production capabilities. They have to hire more people to make the products and pay them more, because they are competing with other companies that also want to hire more people. This stage of the business cycle is known as the maturation stage.
The maturation stage might go on for a long time, but at some point, inflation arises because more people are employed at higher costs, and the costs of materials go up (since companies are buying more and more materials to make their products). This, of course, affects how much profit companies make, since their expenses are going up faster than they can increase the price of the items they are selling. Rising inflation (and hence, rising interest rates) sets the groundwork for the next stage of the business cycle: the contraction or recession stage.
Contraction or Recession
In the contraction stage, inflation, and all the bad things it brings, causes businesses to pull back. They pull back also because they have probably overbuilt factories and bought too many machines to make their products in anticipation of continued demand. With profits going down, they cut back on their equipment purchases, lay off some of the extra workers (especially those hired when things were going great and there was no inflation), cut back on salaries, and take other actions to stop their profits from declining further. With reduced incomes, consumers (or workers) reduce their spending.
The stock market indexes enter a downward phase, or a bear market as it is commonly called. In this stage of the business cycle, businesses and consumers do not borrow as much money to buy equipment and other items. The Federal Reserve may even step in and reduce rates (by lowering the discount rate) to encourage borrowing and spending.
At some point in the recession and contraction phase, things start to turn around. The stock market, after prices have gone down due to reduced profits, begins to move up again. Recall that rates are low at this point (due to the actions of the Federal Reserve), so people are willing to give up the low rates in bonds to move back into stocks. This sets the stage for the next phase of the business cycle – the revival stage.
In the revival stage, consumers start to feel more confident that the worst is behind them, and they start to spend again. Economic indicators like the GDP start to move higher after long periods of decline, employment numbers start to look good again, some businesses start to spend more money again. So after months or years of being in the doldrums, things begin to improve. This creates conditions for the next stage of the business cycle – the expansion stage.
In the expansion stage, the revival continues and many more businesses benefit from a good economy, not just a few businesses in specific industries. Companies that require heavy investments, such as housing construction companies and appliance manufacturers, fully benefit from a good economy. The bull market is back.
The next stage after expansion is the maturation stage. And we are right back where we started, with the economy humming, and the Dow and the S&P 500 making investors very happy.
Why It Is Hard To Spot Some Stages of the Business Cycle
In truth, it is sometimes difficult to tell when the economy makes the transition from the expansion to the maturation stage (although the Federal Reserve can help a bit to prolong the expansion).
A contraction stage is easier to spot. A high unemployment rate and other signs of stress in the economy can give you a clue about when contraction has set in. We witnessed such a severe contraction during “The Great Recession” that occurred in 2008, with accelerating job loss and the GDP on its way to extremely low levels.
Suppose you knew the exact time a stock would hit its lowest and highest levels in the business cycle. If you knew the exact pattern of a business cycle, you would want to buy the stock at its lowest level and sell it at its highest level (when the Dow and the S&P 500 are at their highest and are just about to come down). As a Teenvestor, you can make a fortune if you have the skill to predict the length of the cycles. Unfortunately, no one knows how long each stage of the business cycle will last. In addition, no two business cycles have exactly the same pattern.
Therefore, you can’t just use a calendar to tell when a new business cycle will begin and end. At the time of this writing, experts say that we are in the midst of a 10-year expansion, the longest in the history of the United States. Of course, no one knows when this stage of the cycle will end and move into the maturity and contraction stages.
It is worth repeating that the Federal Reserve tries to moderate the good times in the market by raising and lowering the discount rate. However, despite its efforts, business cycles still occur, although not necessarily with the same sting to the economy. The Federal Reserve simply tries to soften the blow when things are bad and, at the same time, makes sure that the good times don’t get out of hand (which can cause more inflation). When the Fed slows an overheated economy down without causing a recession, this is known as a soft landing.