What is an economic cycle?
Although many theories explain the causes of economic cycles, most generally agree on four phases: expansion, peak, contraction, and recovery.
Phase 1: Expansion/Stock market boom
During the expansion phase, interest rates are typically low, making it easier for consumers and businesses to borrow money. Demand for consumer goods increases, and companies ramp up production to meet consumer demand. To increase output, businesses may hire additional labour or invest capital in expanding infrastructure and operations. Overall, corporate profits begin to rise along with stock prices. Gross Domestic Product (GDP) also increases as the economy enters the "boom" phase of the cycle.
Phase 2: Peak/Stock market reaches peak
In this phase, the economy reaches the maximum growth rate. As consumer demand increases, businesses cannot increase production and supply to meet the growing demand. Companies may need to expand production capacity, requiring increased spending or investment. Businesses may also begin to experience rising production costs (including wages), leading some to pass these costs on to consumers through higher prices.
Phase 3: Contraction/Stock market decline
Subsequently, economic contraction begins. During this phase, corporate profits and consumer spending decline, especially on discretionary items (e.g., luxury goods). Stock values also decrease as investors reallocate investments to "safer" assets such as bonds, other fixed-income securities, and cash reserves. GDP shrinks due to reduced spending. Production slows down to match reduced demand. Employment and income may also decrease as businesses temporarily halt hiring or lay off workers. Overall, economic activity slows down, stocks enter a bear market, and economic recession often occurs.
Phase 4: Recovery/Stock market rebounds
The recovery phase is when the economy hits bottom and begins a new cycle. Policies enacted during the contraction phase begin to show results. Businesses that suffered during the recession period started to recover. Stock values tend to rise as investors see potential profits from stocks outweighing bonds. Production increases to meet growing consumer demand, along with expansion in business, employment, income, and GDP.
Investment Allocation Across Phases
Can investors use the economic cycle model as a valuable map to navigate investments? If the phases can be identified, is the task simply about timing market entries and exits at the beginning of each phase?
Investing is more complicated. What makes it challenging is that cycles vary in length. For example, from 1857 to 2020, the National Bureau of Economic Research (NBER) has recorded cycles ranging from as short as two months to as long as 65 months.
Economic cycle models can be implemented, but investors need to dedicate significant time to research, along with continuous monitoring and an approach that acknowledges that successful timing is elusive in investment decisions. This helps investors identify which sectors tend to perform better in each phase of the economic cycle. Going all-in on any one industry is rarely a good idea. Even the most innovative investment minds sometimes make mistakes, so investors are best served by spreading those eggs across many baskets, diversifying to capitalize on sectors that may outperform the market sooner.
