What is a Business Cycle?

By Sean Stevenson – Latest Revision January 12th, 2021

What is a Business Cycle?

A business cycle is defined as the inherent fluctuations in the economy that ubiquitously occur over time. 

This cycle of expansion and contraction produces a “wave-like” pattern, whereby global economic activity consists of either generalized growth or significant contraction. 

This economic activity occurring at about the same time produces a general trend in the marketplace.  It can be readily measured and observed.  As a general rule, economic expansionism is always followed by a series of globalized recessions.

These dominant trends always occur within a similar time frame.  The intervals between each economic peak, or each recession, is typically considered a representation of a full business cycle.  The average cycle is estimated to last over five years on average (based on data metrics that have been accounted for since 1945-2009).

There are typically four primary stages to a business cycle:

  1. Expansion: The economy grows at a healthy percentile of 2% – 3% overall.  During this general phase, stocks enter into a rallying bull market.
  2. Peak: The economy reaches new highs and grows at rates of around 3%.  Inflation begins to take hold and sends prices steadily higher.  The stock market enters a sate of irrationality, with prices far removed from underlying fundamentals.  Asset bubbles come into play, and are deemed as somehow “normal.”
  3. Contraction: Economic growth slows steadily, yet remains above negative ratios.  Stocks begin to end their bull market run.  A bear market takes hold.
  4. Trough: The economy contracts steadily.  Tell-tale signs of a recession are signaled, and panic begins to take hold of consumers. 

It should be noted that a business cycle is not to be confused with a market cycle.  A market cycle is a reflection of the stock market -not the general economy.  It uses stock price indices as a metric of its own growth or decline.

What Is Business Cycle

The image above depicts the full life of a single business cycle.  It also shows the various stages of economical activity involved. 

As this would indicate, the essential essence of a business cycle is a series of economic expansions and contractions.  This aggregation of economic activity is often marked by numerous variables and metrics in the media.  These tend to give important insights into the key causes behind each phase.

A key metric of national aggregate economic activity is the gross domestic product (or GDP).  When combined with adjustments for inflation, industrial productivity, income levels, employment, and sales, a clear picture of a country’s economic status can be discerned by analysts.

A business cycle’s peak and trough dates can be discovered using economic indicators.  Moreover, they can be applied globally.  This allows for an analysis of geo-economics within a certain timeframe.

Key Takeaways

  • A business cycle is typically a 5-year period represented by the concerted economic expansion and contraction phases.  These are accompanied by key economic metrics that define the characteristics of a particular upswing or a downswing. 
  • General contractions or expansions within a business cycle are made up of trending economic factors.  These occur simultaneously across the globe. 
  • When economic expansionism ends, a contraction (also known as a recession) begins.
  • The strength of an economic expansion is based on how pronounced, pervasive, and persistent its activity appears. 
  • The intensity of a recession is measured by its depth, diffusion, and finally, its duration.
  • A new business cycle starts only after the next phase of expansion begins.  This means it must follow the end of the previous cycle’s recessionary period.  It marks a new phase of economic growth.
  • The broad measurements of economics are output, income, employment, and sales.

Pro Tip:  A common misconception about an economic recession is that it may be defined as two consecutive quarters of decline in realized GDP.  While this is often true, there are exceptions to this rule.  It is not an absolute indicator.

Measuring the exact metrics of economic indicators is by far the most accurate way to determine if a recession is existent or grossly exaggerated.

Defining a Business Cycle Recession

What Is Business Cycle

A recession can be defined as a gross decline in overall employment, income, output, and sales.  This downward trend spreads throughout the economy, from industry to industry, and even nation to nation. 

A recession tends to last more than a few months.  As a rule, it tends to be readily apparent in GDP and industrial production.  It diminishes economic values steadily over time.   

The persistence and severity of a recession is what determines how low the economic trough declines.  Moreover, the characteristics that accompany a recession can vary greatly depending on how it began, along with the nature of the underlying fundamentals that drive the trend further downwards.

Example

An excellent example of an economic contraction that resulted in a global recession, was the financial crisis of 2007-2008. 

Marked by a clear overvaluation (often known as a “bubble”) in the real-estate markets of the United States of America, this bull-market crash was the result of exacerbated and excessive risk-taking by large financial institutions. 

With the valuation of underlying securities tied to the real-estate market plummeting in record fashion, a recession ensued.  The ensuing panic in the financial markets culminated in an international banking crisis.

In short, banks had effectively overleveraged themselves in a deregulated, potentially volatile, and highly overvalued market. 

The ensuing dip in real-estate and financial valuations came to be known as the Great Recession.  Up until this point, it was the most severe global recession since the Great Depression. 

It effectively resulted in the loss of over $2 trillion U.S – a massive sum which was claimed by the decline in the span of mere months.

Defining a Business Cycle Recovery

What Is Business Cycle

Conversely, a business cycle recovery can only begin with the reversal of recessionary trends.  When economic output begins to rise, it can trigger a swathe of productive gains for the broader economy.  This includes metrics such as higher incomes, greater availability of employment, and increasing sales that fuel further growth.

A business cycle recovery must endure and persist for some time, so that it can become self-sustaining.  Once it reaches this point of continual gain, it is effectively feeding its own growth.  A trickle effect can now be felt across the global economy, as entire industries and sectors are steadily revitalized.

Example

The current bull market began following the global financial crisis of 2007-2008.  Since March 2009, we have experienced the largest bull market in history. 

Moreover, the last economic trough recorded was in June 2009, marking a period of unprecedented economic expansion in turn. 

While the current climate of the pandemic COVID-19 has created uncertainty in the marketplace, and caused undesirable metrics such as unemployment to rise, it is still too early to be certain when the next deep trough will occur.

However, as with all cycles, the business cycle itself is still an inevitability.  At some point down the road, our global economy will again enter a deep trough.  This is accompanied by a severe recessionary period marked by instability.

Understanding A Business Cycle

The strength of a peak or the magnitude of a recession are marked by broad indices that are used to measure global economic activity.  The primary metrics used to determine this analogous growth or contraction are:

Output

Output is defined as the quantity of goods or services that have been produced within a specific period of time. 

For the purposes of globalized economics, this would refer to the amount of goods or services that were produced by a country, region, or even by the entire world-economy. 

Analysts will try to decipher the overall output of certain industries, countries, or the global economy as a whole.  This allows them to better understand existing trends.  Moreover, from this information they can attempt to predict what future economic activity might look like.

Employment

Employment is the conditions that allow for individuals to find and participate in full-time paid work.  Analysts will look at how many people are employed, and in what capacity.  Naturally, part-time work also accounts for employment; however, it is often precarious to disregard the distinction between the two. 

For all intents and purposes, an economy should seek to create as many full-time positions of employment as possible, to further strengthen its position in the global economy. 

Precarious or part-time work can often skew important statistics that offer greater insight into the nature of existent market shares.

Income

Money received on a regular basis from work, goods, or services rendered, would be considered income.  For our purposes, the amount of money people are making within a regulated economic framework, is what analysts use to decipher how well an economy is faring. 

If a country’s people are well-educated, and earning high incomes, it can be said they have entered a period of prosperous economic growth (or recovery).

Sales

The exchange of money for commodities, goods, or services, is what can be defined as sales.  In a general economy, the number of sales occurring can help indicate the state of consumerism.  In a healthy economy, sales should be high.  However, in a weakened or fragile economy, sales will tend to be low. 

Analysts will try to understand and compare these trends in sales, to better formulate what is happening in the globalized economy.  They may also compare different industries or markets, for further insight.

Highs and Lows - Otherwise knowns as...

What Is Business Cycle

A peak represents the end an economic expansion.  It is followed by a recessionary period, after which the expansion will begin at the trough (or bottom) once again and continue until the next recession.

 This continual pattern is why the business cycle is named as such.  It is literally a continual cyclical pattern that describes the nature of economic progress.  The general trend is historically always headed upwards.

As much as many of us would like to believe that we can control this cycle, it is in fact, quite impossible to do so.  The nature of our economy is made up of booms and busts.  There is no known alternative.  It is merely within the nature and capacity of capitalism as we know it today.

The dating of recessions and recoveries tend to occur in hindsight.  In fact, it often takes more than eight months for peaks to be recognized, and fifteen months for troughs to be fully understood.

Stock Pricing and the Business Cycle – Potential Indicators

The age old adage “the stock market is not representative of the economy,” is very true.  In the beginning of 2021, we found ourselves with a crippled world economy, due to the prevalence of the pandemic known as COVID-19.  Despite this precarious world economic outlook, the stock market has reached all-time-highs.

It must be noted that investment exuberance has historically been a hallmark of the stock market during times of rapid economic growth.  This makes the current scenario appear precarious.  Some would call this current trend irrational exuberance. 

Irrational exuberance often ignores underlying investment fundamentals.  This can create bubbles within the marketplace, which may represent opportunity for some or a devastating liability for others.  Market booms and corrections tend to create continuous volatility in this situation.

Yet timing the market is not a wise investment strategy, nor is it practical in any sense.  

In reality, no one can predict the stock market.  However, you can take note of what is happening during the business cycle to understand its key indicators.  Using these indicators in tandem can offer deep insights into the general economy. 

The following key indicators will give you a much better idea of where the economy is headed in the future:

S&P 500

One of the most well-known collections of the largest publicly traded companies in the United States of America.  The S&P 500 provides a benchmark by which anyone can gauge the state of the U.S economy.  If the S&P 500 is doing well, you can rest assured that the underlying factors would indicate a growth trend in the marketplace. 

While not by any means absolute, the S&P 500 offers important insight into the general economic attitude of investors.

Housing Markets

Any statistical increase in the amount of construction or the rising valuations of existing housing can indicate a positive trend for the economy.  This would mean the business cycle is in a growth phase.

Opposing this viewpoint, would be slow to non-existent rates of construction and pricing plateaus in real-estate.  This would indicate that the business cycle may be headed for a recession.

Consumer Confidence Index

This index measures how confident consumers are in making purchases in the upcoming 12-month period in which they are polled.  The index is based on a rating system. 

Any rating over 100 indicates that consumers are planning to spend their money and make potentially large purchases.  This would mean that they are confident in market and economical conditions.

A rating lower than 100 indicates that consumers are more inclined to save their money, rather than make any major purchases.

In a weakened or weakening economy, the consumer confidence index will be continuously below 100.  This never bodes well for any economy and should be considered a warning sign.

Unemployment Claims

The number of active workers claiming unemployment is an indication of rising difficulties in the economic outlook. 

Conversely, the opposite is true if unemployment is falling.  That would mean that there are plentiful jobs for everyone, and that the economy is experiencing a growth phase.

Other Market Indicators

There are innumerable indexes and metrics that can be gauged to better understand the current intent of the marketplace.  The UK’s LSE (London Stock Exchange) for example, has often been a bellwether for global economic trends.

While any of these market indicators can be of great use to understanding what is happening at a given time, it is important to view more than one.  By taking as many indicators into account as possible, you will be witnessing a larger contrast.  This can provide deep insights into which market niches are prospering, which are not, and where the general economy is likely to be headed next.

Expansions vs. Recessions Over Time

In the U.S, expansions have generally outlasted their corresponding recessions.  Marked by increased standards of living, and greater volumes of wealth, many nations follow this exact trend.

During the WWII period, recessions were far more severe.  Cyclical volatility and recessionary severity has decreased greatly in more modern times.  As a corollary, economic periods of expansion have nearly doubled, proving the validity of globalized economic theory.

This points to a highly positive trend for global outlooks and market prospects, economically speaking.

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