Investors often pay attention to the ups and downs of economic activity — fluctuations known as the business cycle — and readjust their investments accordingly. With this business cycle investing strategy, investors typically adjust their exposure to various sectors with stocks or bonds in their portfolios. Some industries outperform during economic expansions, while others do better during contractions.
Business cycle investing is not an exact science, and past performance isn’t indicative of future returns. But historically, specific industries have prospered during each stage of the business cycle. Here’s a rundown of the different business cycle stages and which industries have been more favorable to invest in during each phase.
Key Points
• Business cycle investing involves adjusting investments based on economic fluctuations, with different industries performing better during various stages of the cycle.
• The business cycle includes expansion, peak, contraction, and trough phases, each affecting investment strategies differently.
• During expansions, consumer-oriented sectors and industries benefiting from business investment tend to thrive.
• Recessions see industries like healthcare, consumer staples, and utilities performing well due to consistent demand.
• Business cycle investing requires understanding economic indicators and market trends, but it can be challenging due to unpredictability.
What Is a Business Cycle?
A business cycle refers to the periodic expansion and contraction of a nation’s economy. Also known as an economic cycle, it tracks the different stages of growth and decline in a country’s gross domestic product (GDP), or economic activity.
Worker productivity, population growth, and technological innovations are all factors that can contribute to whether an economy is going through a period of boom or bust. Such elements play a role in how many goods and services a nation’s businesses produce and how much its consumers purchase.
Other factors, such as wars, pandemics, natural disasters, and political instability, can also influence the economy. These can cause a recession to happen sooner or otherwise shift the economic environment of a nation or the world.
In the U.S., the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) announces whether the economy is in a recession or a new iteration of the business cycle. Policymakers attempt to manage the business cycle by adjusting fiscal and monetary policies, such as taxes, stimulus packages, or interest rates.
Some people refer to business cycles and market cycles interchangeably. However, the business cycle measures the entire economy, while market cycles refer to the ups and downs of the stock market. Although the two can be correlated, they aren’t the same.
How Does the Business Cycle Work?
The business cycle works by alternating between periods of economic growth and decline. During the expansion phase, economic activity grows, and the economy is relatively healthy. A period of economic expansion is typically characterized by low unemployment, rising wages, and increasing consumer and business confidence.
Eventually, the economy will reach its peak and start to contract. This is typically characterized by slowing economic growth, rising unemployment, and declining consumer and business confidence. As businesses see a decline in demand, they may lay off workers or reduce production, leading to a downward spiral of declining economic activity.
The trough phase is the lowest point in the business cycle. Economic activity is at its weakest, and unemployment is at its highest. This phase is also known as the recession bottom. From here, the economy begins to recover, and the business cycle starts over again.
How Reliable Is the Business Cycle?
The business cycle is a reliable pattern of economic activity observed over time, but it is not always predictable. Business cycles tend to follow a similar pattern, with periods of expansion followed by periods of contraction, but each phase’s timing, length, and severity can vary significantly.
Stages of the Business Life Cycle
There are four stages of the business cycle, which fall into two phases: a growth phase of expansion and a declining phase of contraction. A business cycle can last anywhere from one year to 10 or more years. Since 1945, there have been 12 business cycles.
Stage 1: Recession
The recession phase is the lowest point in the business cycle. Also known as the contraction phase, a weak economy and high unemployment define this period.
GDP, profits, sales, and economic activity decline during this stage. Credit is tight for both consumers and businesses due to the policies set during the last business cycle. It’s a vicious cycle of falling production, incomes, employment, and GDP.
The intensity of a recession is measured by looking at the three Ds:
• Depth: The measure of peak-to-trough decline in sales, income, employment, and output. The trough is the lowest point the GDP reaches during a cycle. Before World War II, recessions used to be much deeper than they are now.
• Diffusion: How far the recession spreads across industries, regions, and activities.
• Duration: The amount of time between the peak and the trough.
A severe recession is called a depression. Depressions have deeper troughs and last longer than recessions. The only depression that has happened thus far was the Great Depression, which lasted 3.5 years, beginning in 1929.
Recessions generally lead to shifts in monetary policy and government spending that lead to a recovery phase.
Stage 2: Early Cycle
Following a recession, the economy enters an expansion phase, where there tends to be a sharp recovery as growth begins to accelerate. The stock market tends to rise the most during this stage, which generally lasts about one year. Because of loose monetary policy by the central bank, interest rates are low, so businesses and consumers can borrow more money for growth and investment. GDP begins to increase.
Just as a recession is a vicious cycle, recovery is a virtuous cycle of rising income, employment, GDP, and production. And similar to the three D’s, a recovery period, which includes Stages 2-4, is measured using three P’s: how pronounced, pervasive, and persistent the expansion is.
Stage 3: Mid-Cycle
The mid-cycle phase is generally the longest phase of the business cycle, with moderate growth throughout. On average, the mid-cycle phase lasts three years. Monetary policies shift toward a neutral state: interest rates are higher, credit is strong, and companies are profitable.
Stage 4: Late Cycle
At this stage, economic activity reaches its highest point, and while growth continues, its pace decelerates. Monetary policies become tight due to rising inflation and low unemployment, making it harder for people to borrow money. The GDP rate begins to plateau or slow.
Companies may be engaging in reckless expansions, and investors are overconfident, which increases the price of assets beyond their actual value. Late cycles last a year and a half on average.
What Industries Do Well During Each Stage?
Historically different industries have prospered during each stage of the business cycle, depending on whether they are cyclical or non-cyclical stocks.
When money is tight and people are concerned about the economy, they cut back on certain purchases, such as vacations and pricey clothes. Also, when people anticipate a recession, they tend to sell stocks and move into less-risky assets, causing the market to decline.
Industries do better or worse depending on supply and demand, and the need for specific products shifts throughout the business cycle. In general, the following sectors perform well during each stage of the business cycle:
Recession
During the recession phase, the lowest point in the business cycle, economic activity is at its weakest, and unemployment is at its highest. Many industries may struggle during this phase, especially those dependent on consumer spending or business investment.
However, certain industries are able to weather the storm during a recession because they offer products and services that people need no matter how the economy is performing. These industries include healthcare, consumer staples, and utilities.
Recommended: How to Invest During a Recession
Early Cycle
During the early cycle expansion phase, when economic activity is growing and the economy is healthy, many industries tend to do well. These can include consumer-oriented sectors, such as retail and leisure, as well as industries that benefit from increased business investment, such as construction and manufacturing. Other sectors that benefit from increased borrowing due to low interest rates include financial services, real estate, and household durables.
Mid-Cycle
During the mid-cycle phase, when the economy is operating near full capacity, some industries may start to see slowing growth or declining profits. These can include industries sensitive to changes in consumer demand or highly competitive, such as technology and media. However, some industries perform well during the mid-cycle, like information technology and energy, because companies in these areas deploy capital that helps them grow.
Late Cycle
During the late cycle, economic activity slows down and the labor market shows signs of weakness. Additionally, the economy may face inflationary pressures due to the previous period of economic growth and low unemployment. While this inflationary pressure and economic slowdown negatively impact many industries, utilities and energy companies may do well during this period. Additionally, investors could research stocks that do well during volatility.
Who Should Invest With the Business Cycle?
Business cycle investing involves trying to anticipate changes in the business cycle and buying or selling assets based on the expected performance of those assets during different phases of the business cycle. For example, an investor following a business cycle investing strategy might buy stocks when the economy is expanding and sell them before the peak in anticipation of a downturn.
However, this active online investing strategy is not suited for everyone. Investing and rebalancing a portfolio with the business cycle is difficult because timing the market is easier said than none. Business cycle investing is best for investors who have the time to stay up to date with the latest economic indicators and stock market news while also having the risk tolerance to time the market.
In contrast, some investors prefer a long-term buy and hold strategy, in which they don’t try to time the market and make few changes to their portfolio. For many investors, that may actually be a wiser strategy, though it’ll depend on the individual investor’s preferences, strategy, and goals.
Recommended: Is Stock Market Timing a Smart Investment Strategy?
Pros and Cons of Business Cycle Investing
Business cycle investing involves trying to anticipate and profit from changes in the business cycle. The goal is to buy assets likely to do well during certain business cycle phases and sell them before the next phase begins.
However, investors should note that the business cycle is not always predictable, and there are no guarantees that a business cycle investing strategy will be successful. Thus, it’s good to consider the pros and cons of business cycle investing.
Pros
The advantages of using a business cycle investing approach include the following:
• The ability to potentially profit from changes in the business cycle: By anticipating and acting on changes in the business cycle, investors may profit from the upswing of a recovery or the downtrend of a recession.
• A framework for decision-making: The business cycle provides a framework for analyzing economic trends and making investment decisions. This can help investors make more informed decisions about buying or selling assets.
• Diversification: Business cycle investing can help investors diversify their portfolio by adding assets likely to do well in different phases of the business cycle.
Cons
The disadvantages of using a business cycle investing approach include the following:
• Difficulty in predicting the business cycle: The business cycle is not always predictable, and it can be difficult to anticipate changes in the economic environment. This can make it challenging for investors to implement a business cycle investing strategy successfully.
• Market volatility: Business cycle investing can involve buying and selling assets at different points in the business cycle, exposing investors to stock volatility.
• Opportunity cost: By focusing on the business cycle, investors may fail to take advantage of opportunities to invest in assets that are not correlated to the business cycle but may still provide strong returns.
The Takeaway
No business cycle is identical, but history shows there can be a rough pattern to which industries do better as the economy expands and contracts. Investors can take cues from which stage of the business cycle the economy is in order to allocate money to different sectors.
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FAQ
What is an investment cycle exactly?
An investment cycle is a pattern of investment activity that occurs over time, usually in conjunction with the business cycle. It is typically characterized by periods of rising prices followed by periods of declining prices. The length and severity of the investment cycle can vary, and various factors, including economic conditions, market trends, and investor sentiment, can influence it.
How long are investment cycles?
The length of investment cycles can vary significantly, depending on economic activity and investor sentiment. Some investment cycles may last only a few months, while others may last several years or more.
What are the 4 stages of investment cycles?
The four stages of an investment cycle are expansion, peak, contraction, and trough.
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