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An Investors Guide to the Business Cycle

Shauna O'BrienJul 22, 2015
2015-07-22
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The rise and fall of the economy in America and elsewhere can generally be classified into a cyclical pattern
that repeats itself over and over. Although their timing can be hard to predict, those who are able to recognize
them when they occur can use this to their financial advantage in many cases. Learn the characteristics of each
major phase of the cycle and the possible ramifications that they may have on your investment portfolio.

The 4 Basic Phases

A complete economic cycle can be broken down into four subcategories: expansion, peak, contraction and
trough. The U.S. economy typically goes through an entire cycle in a period raging from six months to about 5
years. The length of each phase of the cycle will vary according to current economic conditions and the overall
length of the cycle.
Expansion

The expansion phase begins when the economy finally begins to recover from a recession. During this phase,
the Fed will usually start to ease its monetary policy and thus allow credit to become more available. This
injects money and liquidity into the economy, which stimulates further growth and boosts the earnings of
corporations. As the economy solidifies, consumer discretionary income increases and leads to greater
spending. The stock market begins rising and economic numbers improve.
Peak
After a period of expansion, growth finally starts to taper off and corporate earnings reach their peak. Consumer
spending continues and interest rates bottom out. Stock prices level off and often begin to retrace the most
recent segment of their growth. This phase of the cycle usually lasts longer than any other.
Contraction
Economic growth eventually starts to slow and inflation begins to spiral upward. Consumer pessimism asserts
itself. Economic numbers start to wane and unemployment rises.
Trough
This is the period of recession where the economy bottoms out. The money supply has virtually dried up and the
Fed is raising interest rates in order to curb inflation. The markets are hitting a low as company profits recede
and consumer spending has slowed to a trickle. This phase will of course eventually give way to a new period
of growth that starts the cycle over again.

How to Profit from Economic Cycles

Although investors who are able to ride out the rise and fall of economic cycles over long periods of time can
still reap substantial returns, those who adjust their portfolios and strategies for each segment of the cycle can
achieve superior returns over shorter periods in many cases. For example, the entertainment industry typically
sees a spike in business during recessions, because the demand for something that allows consumers to be able
to forget about their financial woes for even a short time becomes very strong during this period. The stock
market is generally viewed as a leading indicator of the economy, as both its growth as well as its decline has
historically preceded that of the economy. This is primarily because the markets tend to look forward, so to
speak, as their performance depends heavily upon future projections while economists compute their numbers
based upon recent historical data. Therefore one way that you could apply this knowledge would be to see how
a recession can lead to lower interest rates, because lowering rates is the traditional tool that the Fed uses to
stimulate economic growth. And when interest rates fall, bond prices rise, which means that it may be a good
time to buy them. Then, when the economy reaches its next peak, you can sell those bonds at a profit, because
they will begin to fall again in price because rates are now low. Another idea is to get into consumer cyclicals
and financial stocks during early periods of growth, because these stocks are especially sensitive to interest rates
and will often rise in value faster than the market as a whole.

Market Indicators
One of the ways that economists determine where we are in the economic cycle is by watching various
economic indicators, such as Gross Domestic Product, interest rates, inflation, employment numbers and
productivity. Rising inflation indicates economic growth while falling GDP and employment figures reflect
periods of contraction.

Time the Market with Sector Funds

Although market timing is an inexact science fraught with peril and uncertainty, those who decide to attempt
this can improve their odds by watching the economic cycles and moving their money to the appropriate sectors

during the various stages of the cycle. As mentioned previously, consumer cyclicals, transportation and
technology stocks can be good picks during a recession, as they tend to flourish when the economy starts to
recover. Then, when the economic recovery shifts into high gear, other sectors often experience periods of
strong growth, such as precious metals, healthcare, energy and capital goods. Commodities also typically peak
when the economy starts to cool off again.
If you are going to try a strategy that requires market timing, you should probably look to ETFs that invest in
each of these sectors in order to maximize your liquidity and minimize trading costs. Also remember that there
will not necessarily be a unanimous consensus on exactly when we enter or leave a particular phase in the cycle,
and you will ultimately have to decide for yourself when to shift your portfolio from one sector to another.

The Bottom Line

Economies have moved in the cycle described above since the dawn of civilization. Investor who understand
how these cycles work can profit from them over time by continuously shifting their money into the sectors that
are profiting from the current phase of the cycle. ETFs such as the ones offered by Blackrock Capital now make
it easy to invest directly in any sector or subsector of the market. For more information on economic cycles and
how you can profit from them, visit Blackrock Capitals ETF website at www.ishares.com or consult your
financial advisor.
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