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. 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.
The Maturation Stage
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 products for consumers. They have to borrow money to invest in more equipment in order 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 who also want to hire more people. This stage of the business cycle is known as the maturation stage.
The Contraction Or Recession Stage
The maturation stage might go on for a long time but at some point, inflation rears its ugly head 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.
In the contraction stage of the business cycle, 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 for their products. Given the fact that their profit is 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 further declining. 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, business and consumers do not borrow as much money to buy equipment and other items. The Federal Reserve may even step in to reduce rates (by lowering the discount rate) in order to encourage borrowing and spending.
The Revival Stage
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 of the business cycle, 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 look good again. This sets the stage for the next stage of the business cycle--the expansion stage.
The Expansion Stage
In the expansion stage of the business cycle, 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 again.
The next stage after expansion is the maturation stage. And we are right back where we started with an economy that is in full gear, with The Dow and the S&P 500 making investors very happy.
In truth, it is sometimes difficult to tell whether the economy is in the expansion or in the maturity stage because at some point, the expansion stage moves into the maturity stage (although the Federal Reserve can help a bit to prolong the expansion).
A contraction stage is easier to spot once you are in it. A high unemployment rate and other signs of stress in the economy can give you a clue about when contraction has set in.
The Difficulty In Knowing How Long
Each Cycle Will Last
Suppose you knew the exact time a stock will hit its lowest level and its highest level in the business cycle. If you knew the exact pattern of a business cycle, you would want to buy the stock when it has hit its lowest level, and sell it when it has hit 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. In April 2000, the U.S. was in the tenth year of an expansion -- the longest expansion in the history of the United States. That expansion came to an end by 2001 after the crash of the high tech segment of the economy and after the tragedy in New York City now called 911.
Why The Fed Tries To Moderate The Business Cycle
It is worth mentioning here 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 Federal Reserve slows an overheated economy down without causing a recession, this is known as a soft landing.