We refer to it by different names: boom and bust; expansion and contraction; growth and recession; and the proverbial bull and bear. What we’re talking about is the economic cycle, aka “business cycle.”
Economic cycles are the recurrent boom-and-bust phases that markets and economies typically exhibit. Think of it like a wave:
The of the cycle is easy to imagine, but what actually happens in the economy during its entire span? What causes economic cycles? And is it possible to position your investments to take advantage of the different phases?
The economy is characterized by ups and downs in economic activity over time. These fluctuations are referred to as the business cycle and can be broken down into 4 main phases expansion peak contraction, and trough. As a business owner or investor, having a solid grasp of these phases can help you make more informed decisions.
In this article I’ll provide an in-depth look at each of the 4 phases of the business cycle. We’ll explore what drives each phase key indicators to watch, and strategies to consider during each stage. Whether you’re looking to grow your business, invest wisely, or just understand economic trends, this guide aims to give you the knowledge you need on the phases of the business cycle.
Phase 1: Expansion
The expansion phase represents a period of economic growth. During expansions, there is high output, low unemployment, and rising prices due to strong demand and production. Consumers and businesses are spending more, boosting overall economic activity.
Some key indicators of the expansion phase include
- Increasing GDP
- Low and falling unemployment rate
- Strong growth in retail sales
- Rising corporate profits
- Increasing inflation
- Bullish stock market
For businesses and investors, the expansion phase offers opportunities for growth and profits. Consumer confidence is high and there is greater appetite for spending. However, rising inflation and potential overheating of the economy can emerge as threats later in the expansion.
Strategies for Expansion
- Expand production and operations to meet rising demand
- Invest in new products, equipment, and markets
- Hire more employees to support growth
- Consider increasing prices moderately in line with demand
- Monitor inflation carefully towards the end of the expansion
Phase 2: Peak
The peak represents the transition point between economic expansion and contraction. It is the highest point of output and employment in the business cycle before the economy heads into a downturn.
Indicators that a peak is occurring include:
- Slowing GDP growth
- Spiking inflation
- Tight labor markets
- Falling consumer confidence
- Declining corporate profits
- Bearish stock market activity
The onset of a peak does not mean a recession is imminent. However, it does signal that the period of expansion is coming to an end. At the peak, the economy is usually operating at or above full capacity.
Strategies for the Peak
- Exercise caution in overexpanding – restraint now can prevent overextending later
- Monitor inflation and quality of debt in the system
- Consider locking in profits from investments
- Tighten budgets and watch for weakening demand and revenue
Phase 3: Contraction
After the peak, the economy enters the contraction or recession phase. This involves a slowdown in economic activity as demand declines. High unemployment, falling investment and consumer spending, and reduced output characterize contractions.
Signs of sliding into a contraction include:
- Negative GDP growth
- Rising unemployment
- Declining retail sales
- Plummeting consumer and business confidence
- Falling prices and profits
- Bearish stock markets
Contractions vary in their severity and duration. They can last anywhere from a few months to over a year. Economists declare a recession when contractions persist for a sustained period and meet formal criteria.
Strategies for Contraction
- Cut costs, overheads, and trim excess capacity
- Reduce debt and improve cash reserves
- Lower prices to attract customers as demand falls
- Hold off large investments and expansions
- Identify most profitable products/services to focus on
Phase 4: Trough
The trough represents the lowest point of economic activity before the cycle heads into an expansion phase again. It indicates a transition from contraction to growth.
Some signals of hitting the trough include:
- GDP growth turning positive
- Unemployment rate leveling off
- Stabilizing or rising consumer sentiment
- Improving retail sales
- Increasing business investment
- Rising stock prices amid renewed optimism
The trough phase can persist for some time as the economy regains momentum. Businesses and consumers regain confidence slowly after a contraction. However, it plants the seeds for the next expansion.
Strategies for the Trough
- Begin investing in new opportunities and growth plans
- Develop new products and services to meet changing demand post-recession
- Refocus on quality staff and training
- Repair balance sheets by reducing debt and improving liquidity
- Prepare marketing plans to capture returning demand
Key Takeaways on the Business Cycle Phases
The 4 phases of the business cycle do not follow a fixed schedule but are a useful framework for tracking the economy. By recognizing the signs of each phase, businesses and investors can adopt appropriate strategies. The impact on different industries varies across the cycle – for example, consumer staples suffer less in contractions than discretionary purchases.
Watching leading indicators like GDP, unemployment, consumer sentiment, and others can provide early signals of phase changes. While economic evolution is complex to predict, awareness of where we are in the business cycle is vital context for strategic planning and decision making.
The economy is always changing, and business cycles are a natural phenomenon. By understanding the 4 classic phases and their characteristics, we can make informed choices to both enjoy the benefits and weather the challenges of each stage. Applying the right strategies at the right time goes a long way towards sustaining success through the ups and downs.
Cycling your investments through the phases
Can you use the economic cycle model as an actionable map to plot out investments? It’s a tempting prospect. After all, if you can identify the phases, all you have to do is match your market entries and exits to the start of each phase, right?
If only investing were that simple.
What makes it tricky is that the cycles vary in length. For example, from 1857 to 2020, we’ve seen a peak-to-trough cycle as short as two months and as long as 65 months, according to the National Bureau of Economic Research (NBER).
Economic cycle models are actionable, but it takes plenty of research, plus constant monitoring and the unavoidable hit-or-miss approach in timing your investments. It also helps to know which sectors tend to perform better in each phase of the economic cycle.
It’s rarely a good idea to go all-in on any sector. Even the most brilliant investing minds are wrong from time to time, so it’s best to keep those eggs spread among many baskets. But you can certainly change your allocations to try to capitalize on sectors that may soon outperform the market.In an up-and-down market, dollar cost averaging actually lowers your average entry price.Encyclopædia Britannica, Inc.
Four phases of an economic cycle
Although there are numerous theories explaining what causes economic cycles, most generally agree on the four phases: expansion, peak, contraction, and recovery.
Phase 1: Expansion. During the expansion phase, interest rates are often on the low side, making it easier for consumers and businesses to borrow money. The demand for consumer goods is growing, and businesses begin ramping up production to meet consumer demand. To increase production, businesses hire more workers or invest capital to expand their physical infrastructure and operations. Generally, corporate profits begin to rise along with stock prices. Gross domestic product (GDP) also begins rising as the economy gets its “boom” cycle underway.
Phase 2: Peak. At this stage, the economy reaches a maximum rate of growth. As consumer demand rises, there’s a point at which businesses may no longer be able to ramp up production and supply to match the increasing demand. Some companies may find it necessary to expand production capabilities, which entails more spending or investment. Businesses may also begin experiencing a rise in production costs (including wages), prompting some to transfer these costs over to the consumer via higher prices.
Consequently, businesses may begin to see a “topping-off” in profits despite charging higher prices. Other businesses will see decreasing profits due to higher manufacturing (input) costs or higher wage demands. Overall, inflationary pressures start to build up, or “bubble,” and the economy begins to overheat.
Typically, the Federal Reserve will hike interest rates to combat rising prices—making it more expensive to borrow money—in an attempt to cool the economy.
Phase 3: Contraction. Then the economic contraction begins. In this stage, corporate profits and consumer spending, particularly on discretionary (e.g., luxury) items, begins to fall. Stock values also decline as investors move their investments to “safer” assets such as Treasury bonds and other fixed-income assets, plus good ole cash. GDP contracts due to the decrease in spending. Production slows to match falling demand. Employment and income can also decline as businesses temporarily freeze hiring or resort to laying off workers. Overall, economic activity slows, stocks enter a bear market, and a recession typically follows.
Sometimes a recession is mild, but other contractions—such as the Great Depression—are particularly severe and long-lasting. In a depression, many businesses close up shop for good.
If the economy looks to be suffering a severe contraction, the Federal Reserve tends to lower interest rates so that consumers and businesses can borrow money on the cheap for spending and investment. Lawmakers may tweak tax policy and/or call on the Treasury Department to issue economic stimulus in order to stoke consumer spending and demand for goods and services.
Phase 4: Recovery. The recovery phase is when the economy hits its trough, bottoms out, and begins the cycle anew. Policies enacted during the contraction phase begin to bear fruit. Businesses that retrenched during the contraction begin to ramp up again. Stock values tend to rise as investors see greater potential returns in stocks than bonds. Production ramps up to meet rising consumer demand and with it, business expansion, employment, income, and GDP.
Business Cycle Phases
What are the 4 stages of a business cycle?
The four fundamental stages of the business cycle are expansion, peak, contraction and trough. The National Bureau of Economic Research (NBER) measures the business cycle by analyzing quarterly gross domestic product (GDP). What is the business cycle? The business cycle is the increases and decreases in the economy over time.
What are the 4 stages of an economic cycle?
An economic cycle, or business cycle, has four stages: expansion, peak, contraction, and trough. The average economic cycle in the U.S. has lasted roughly five and a half years since 1950, although these cycles can vary in length. Factors to indicate the stages include gross domestic product, consumer spending, interest rates, and inflation.
What are the alternating phases of a business cycle?
Business cycles are composed of concerted cyclical upswings and downswings in the broad measures of economic activity—output, employment, income, and sales. The alternating phases of the business cycle are expansions and contractions. Contractions often lead to recessions, but the entire phase isn’t always a recession.
What is the business cycle?
The business cycle is the four stages of economic expansion and contraction. Learn more about each stage and what they mean for U.S. businesses and consumers.
