The Economic / Business Cycle

Every major industrialized country experiences recurring patterns of economic growth and contraction, which are expressed in terms of the country’s total output of goods and services — its gross domestic product (GDP). This cyclical behavior, which generally lasts three to five years, is referred to as the business (or economic) cycle.

A typical business cycle has the following phases: expansion, peak, contraction, trough, and recovery.

Expansion Phase

During the expansion phase, economies grow at a healthy rate and corporate profits tend to rise. Meanwhile, both short- and long-term interest rates tend to be relatively low and most people that seek employment are able to secure a job.

In addition, manufacturing plants tend to increase their operating capacities in an effort to meet increases in consumers’ demand for both durable (i.e. homes, automobiles, and consumer electronics equipment) and non durable goods (i.e. clothing, groceries, and books).

Peak Phase

During the peak phase, economies grow at a rapid rate, virtually everyone that wants a job is employed, manufacturing plants tend to operate at full capacity, and both commodity prices and inflation rates tend to rise to high levels. In addition, both short and long-term interest rates tend to rise, as central banks (i.e. the Federal Reserve) reduce the money supply in an effort to contain inflationary pressures and the demand for loans increases in response to robust economic activity.

Meanwhile, the growth rate of corporate profits tends to decline in response to substantial increases in commodity prices (i.e. industrial metals, textiles, and petroleum products) and increases in labor costs.

Contraction Phase

During the contraction phase of the business cycle, economic conditions deteriorate, corporate profits decline, and unemployment rates rise. In addition, businesses tend to reduce their production of goods and services, and commodity prices therefore tend to decline.

Meanwhile, central banks tend to reduce short-term interest rates in an effort to stimulate the economy and to prevent a recession.

Trough

During the trough phase of the business cycle, GDP declines to its business cycle lows and a large number of persons that seek employment are unable to secure a job. In addition, manufacturing plants tend to operate at low capacity levels and both short and long-term interest rates tend to fall to historically low levels in response to substantial declines in the demand for loans.

Meanwhile, corporate revenues tend to decline considerably and a large number of companies tend to generate financial operating losses.

Recovery

During the recovery phase, economies begin to grow again, employment conditions improve, and corporate revenues increase. Meanwhile, both short and long-term interest rates tend to remain near low levels, and both commodity and real estate prices tend to stabilize.

Asset Classes and the Business Cycle

As mentioned above, different asset classes and economic sectors tend to perform differently during different economic environments and during different phases of the business cycle.

Stocks

Stocks tend to perform best during both the recovery and expansion phase of the business cycle, when economic conditions are improving and corporate revenues are rising.

Stock prices tend to be quite volatile during the peak phase of the business cycle, as investors become less certain about the future direction of the economy and corporate profits.

Stocks tend to decline during the contraction phase of the business cycle, when economic conditions are deteriorating and corporate profits are falling.

Real Estate

Real estate tends to perform best during the recovery and expansion phases of the business cycle, when interest rates are relatively low and employment conditions are either healthy or improving.

Real estate tends to perform poorly during the contraction phase, when economic conditions are deteriorating and employment conditions are weakening.

Commodities

Commodities tend to perform best during the middle and late expansion phases of the business cycle, when manufacturing plants are operating either at or near their full capacity and the demand for industrial metals, textiles and petroleum products are at their business cycle highs.

Commodities tend to perform poorly during the contraction, when manufacturers are reducing their production of goods and operating at less than full capacity.

Precious Metals

Precious metals tend to perform best during the peak stage, when the industrial demand for gold and silver rises to high levels and inflation rates increase substantially.

Precious metals tend to perform poorly during the contraction phase, when the industrial demand for those metals declines and inflation rates decline.

Bonds

Bonds tend to perform best during the late-contraction phase of the business cycle, when both short-and long-term interest rates tend to decline.

Bonds tend to perform poorly during both the late-expansion and peak phase of the business cycle, when both short and long-term interest rates tend to rise.

Economic Sectors and the Business Cycle

The equity securities of companies that operate in different economic sectors also tend to perform differently during the various stages of the business cycle.

Financial Sector

Stocks of companies that operate in the financial sector tend to bottom during the trough phase of the business cycle and to rally sharply during the recovery stage, as central banks reduce short-term interest rates, the employment situation improves, and the demand for loans increases.

This sector of the market also tends to perform well during both the middle and late-expansion phase, when businesses increase their demand for loans to invest in capital equipment and consumers increase their demand for loans to buy homes, automobiles and various other durable goods (i.e. appliances, furniture, and consumer electronics equipment).

Consumer Discretionary Sector

Companies that operate in the consumer discretionary sector include retailers of apparel and consumer electronics equipment, bookstores, entertainment companies, restaurants, and hotel chains.

Because those types of companies tend to be very susceptible to changes in interest rates and consumer incomes, the equity securities of consumer discretionary companies tend to perform well during both the recovery and expansion phases — when interest rates are relatively low and consumer incomes are rising.

Technology Sector

Stocks of companies that operate in the technology sector tend to perform well during both the recovery and expansion phases, when companies in other sectors are seeking ways to increase their productivity and consumer incomes are rising.

Industrials Sector

Stocks of companies that operate in the industrial sector (i.e. manufacturers of automobiles, industrial machinery, and agricultural equipment) tend to perform best during the middle and late-expansion phases, when unemployment rates tend to be low and consumer incomes, as well as the incomes of businesses that operate in other economic sectors, tend to rise to their business cycle highs.

The fact that industrial companies tend to operate near their full capacity during this stage of the business cycle is another factor that benefits those companies, as companies that operate in the industrial sector tend to have high fixed costs of production.

In addition, worldwide economic growth tends to improve considerably during the middle and late-expansion phases, which often leads to robust gains in the profits of industrial companies and to corresponding increases in those companies’ stock prices.

The equities of transportation companies, which are included in the industrial sector, also tend to increase the most during the expansion phase of the business cycle, as industrial manufacturers ship increasing amounts of their products to their customers via railroads, ships and trucks.

Basic Materials Sector

The equities of companies that operate in the basic materials sector tend to perform best during the late expansion and peak phases, when the demand for their products from industrial manufacturers and electrical utilities companies tends to rise sharply.

As is the case with industrial companies, providers of basic materials (i.e. coal, chemicals, industrial metals, and timber) also tend to perform well during periods of rising global economic growth.

Energy (Oil & Gas) Sector

The energy sector includes large integrated oil and gas companies, oil and gas exploration companies, and energy services companies. Although the companies that operate in those industries tend to have their own dynamics, the financial success of those companies is determined largely by the worldwide supply of and demand for oil and gas products.

The equity securities of companies that operate in the energy sector therefore tend to perform best during the late-expansion and peak phases of the business cycle, when the demand for petroleum products is at its highest.

Consumer Staples Sector

Although stocks in general tend to perform poorly during the contraction phase, stocks of companies that operate in the consumer staples sector (i.e. providers of food, cigarettes, and laundry detergent) tend to outperform stocks of companies that operate in most other economic sectors during this stage of the business cycle.

That’s because the demand for consumer staples tends to be largely unaffected by changes in economic conditions or consumer incomes, even during periods of slowing economic growth, as consumers tend to rely heavily on those types of products for their everyday existence. The profits of companies that operate in the consumer staples sector therefore tend to be relatively stable and the equity securities of those companies tend to decline less during economic downturns than the stocks of companies that operate in most other economic sectors.

Recognizing that fact, portfolio managers who are required to keep their portfolios fully invested in equities at all times tend to rotate a large portion of their holdings into this “defensive” sector of the market during economic contractions and during periods in which stock prices in general are declining.

Healthcare Sector

The equities of companies that operate in the healthcare sector tend to hold up relatively well during economic contractions for the same reasons given for stocks of companies that operate in the consumer staples sector. For example, people who need pharmaceutical products or medical attention are likely to demand those products and services even during economic downturns. As a result of that fact, the equities of companies that operate in the healthcare sector tend to outperform the stocks of companies that operate in most other sectors during the contraction phase of the business cycle.

Telecommunications Sector

Stocks of companies that operate in the telecommunications sector tend to perform well during the early and middle-contraction phase, as few consumers or businesses tend to relinquish their communications services during such periods.

Note: The consumer staples, healthcare, and telecommunications sectors are often referred to as “defensive” sectors. Although the equities of companies that operate in those sectors tend to outperform the stocks of companies in most other sectors during the early stages of an economic downturn, the prices of those stocks tend to fall along with the declines in stock prices in general during the late-contraction phase of the business cycle.

Utilities Sector

Electric companies historically have been very sensitive to changes in the level of interest rates because of the large debt financing costs they incur to build their infrastructures. As a result of that fact, the equities of companies that operate in the utilities sector tend to outperform the equities of companies that operate in other economic sectors during the middle-contraction phase of the business cycle — when central banks tend to implement measures to reduce interest rates in an effort to stimulate growth.