Economic Cycle
It is the cycle of stages that an economy will go through during different economic conditions.
What is the Economic Cycle?
An economic cycle is the cycle of stages that an economy will go through during different economic conditions. An economic cycle is also known as a business cycle. During these cycles, the economy will expand and contract due to different stimulates of the economy.
During these cycles, there are four stages:
- Expansion
- Peak
- Contraction
- Trough
Economic factors such as employment levels, gross domestic product (GDP), supply and demand levels in markets, inflation, and others cause these stages to change.
For example, an economy is more likely to be in an expansion phase of the cycle if the unemployment levels are low and companies hire more people. Most would agree this is a good part of the cycle, as products and services are usually affordable.
These business cycles are measured by going from peak to peak or trough to trough. The National Bureau of Economic Research is where one can find the definite dates of economic cycles. The growth or decline in the gross domestic product generally measures cycles.
These cycles are noteworthy for investors, banks, and other financial institutions because they need to know where the economy is headed. Therefore, these institutions will analyze the markets and the cycles they go through to position themselves better for the future.
If the institutions see the current cycle is starting to expand, they may increase their investing or long-term trades in the future. Investors will plan through different cycles because there are different levels of returns during different cycles.
Since 1854, the U.S. economy has been through thirty-four cycles. However, since World War II, there have been twelve economic cycles. These cycles can take as short as four years to as long as ten years to be completed.
Economic Cycles and Key Indicators
A few different indicators help economic, and finance professionals understand the stage or phase of a cycle. Generally, the GDP and unemployment data will tell professionals the most about the cycle and its direction.
The four stages of a cycle are expansion, peak, contraction, and trough. The GDP and unemployment rates will expand and contract during periods, causing the cycles to fluctuate. There are a few different drivers of GDP and unemployment.
The main driver of economic expansion and contraction is interest rates, these impact companies in a great way. Thus, if companies as a whole are affected, the economy as a whole is affected as well. For example, lower rates increase economic activity.
When interest rates are low, the economy is more likely to boom. For instance, in 2020, when interest rates became exceptionally low, the economy began to pick up after Covid-19 collapsed the markets. The housing market, in particular, blasted off.
In contrast, interest rates were rising in the lead-up to the recession. When interest rates rose, businesses and people spent less. So it did not cause the crash of 2008.
Before, both unemployment and interest rates were low. As a result, loans were easy to obtain; however, when the interest rates began to rise, people could not pay their balloon-interest loans back because the payments had risen too high, and they defaulted on their loans.
This is one of many reasons the market crashed in 2008. It plays a significant role in the stages of business cycles, affecting both the gross domestic product and unemployment rates. Rates will rise and fall.
Analyzing Economic Cycles
Analyzing economic cycles is very important for financial institutions. These institutions will rely on knowing the economy's position and where it could be headed. When they know the economic conditions, they can make decisions regarding investment opportunities.
In the simplest way of thinking, investors and financial institutions investing in equity markets will usually try to find the transitions from expanding to contracting, also thought of as the peak. The other transition would be from a state of contraction to a state of expansion in the economy.
If investors can find the point when the economy is making a change, they will be able to make decisions that will lead to larger returns. In addition, most institutions have professional analysts who can gather data to form an analysis report on the economy.
During the uptrend or expansion of a business cycle, financial institutions will want to buy stock in companies because they will likely increase in price. However, these firms must ensure they have taken advantage of the opportunity to buy low enough to balance the risk to reward.
For example, retail and institutional investors will begin to scale into their positions when markets are down and stabilize. This is how firms position trade; it is truly the definition of buying low and selling high. However, these trades can take a few months to a year.
On the other hand, institutions and investors need to be able to see when the market is beginning to become a little too hot. Another thing that brings markets down is inflation because the federal reserve will want to raise the interest rates when there is high inflation.
As stated before, higher interest rates are not suitable for the economy; they can push the economy into a recession when they become too high. When a recession occurs, investors will likely pull most of their position or investments out of the market unless they plan to hold for years.
A good example is when the Federal Reserve began seeing a significant increase in inflation in late 2021. In December 2021, the Fed decided it would raise interest rates throughout 2022, which caused a large sell-off and possibly a recession.
Those tracking the movements of cycles will usually mark the months, quarters, and years of peaks and troughs. Then they will also account for the duration of the expansions and contractions in months.
Impact of Economic Cycles
The impact of everyday life can be affected by economic cycles; however, the effects are typically delayed. Nevertheless, the processes will most certainly affect the daily price of goods and services people use.
For example:
- The price of gas will rise if the markets are constricting.
- The prices of goods and services are affected because of the supply and demand in the markets. The markets will expand when the economy transitions from the trough to the expansion phase. As a result, more supply will become available, and prices will decrease.
- On the other hand, if the business cycle is transferring from the peak to the contraction phase, the supply of goods and services will become less accessible. When the goods become less accessible, the demand will rise, and the price will be driven higher.
- When the markets contract, the rising prices will squeeze the lower-middle and lower classes. Everyday necessities will become much more expensive, and they will only be able to pay for some of what they need. This is when inflation becomes a threat to the economy.
There are two different measures of inflation.
- The Consumer Price Index (CPI) tracks inflation for the price of goods for consumers.
- The Producer Price Index (PPI) measures producers' inflation.
Both of these indexes release data that is very important for the markets.
The two indexes heavily impact the stock market and where it could be headed. For example, if CPI increases a lot year over year, the financial markets will react negatively. On the other hand, if CPI increases heavily over months, it could cause a bear market.
When data from the PPI data is released, it is not as big of a catalyst for the markets as CPI is. However, it is still essential to track. The PPI shows how producers are affected by inflation; in turn, we can see how it may be affecting consumers.
When inflation rises for consumers and companies, the Federal Reserve will take note of this, and they will most likely take action if needed. The Fed will probably decide to raise interest rates through open market operations.
Raising rates is a tool to slow inflation, making it harder for consumers and companies to borrow money, thus slowing the economy. Generally, when the cycles contract, it hurts the consumers; when the cycles expand, it helps them.
Economic Cycles Examples
There have been many business cycles since the creation of the U.S. economy. However, some cycles were more important and influential than others. Some of the cycles to note are the Great Depression, the dot-com bubble, and the great recession.
1. The Great Depression
During the Great Depression, banks crashed, and industrial production and prices declined massively. When this happened, poverty skyrocketed; however, this event did not just happen in the United States but worldwide.
The depression was caused by a few factors, such as the Smoot-Hawley Tariff Act, the stock market crash of 1929, and the collapse of banks and the money supply. During this time, people were fighting to eat. During this time, crime rates elevated.
Demand was low, and supply and production were extremely high. Families were neck deep in home, auto, and other debts that they stopped spending their income on other consumer goods that were not necessities. This caused a lot of companies to fail.
2. The Dot-Com Bubble
A large amount of over-confidence in the markets caused the dot-com bubble. During this bubble, investors bought lots of equity in dot-com companies without thoroughly looking into them or giving them time to prove themselves.
Had the investors and institutions given the companies time to prove themselves and mature, some of them would have avoided taking such enormous losses on their investments. The considered placement of occurrence of the bubble was to be from 1995 through 1997.
Investors were spending countless dollars on these equities, but soon the companies would not turn a profit and begin to fail. Many of which failed companies such as Worldcom and pets.com. Many of the companies were structured poorly.
3. The Great Recession
The Great Recession was caused by many mortgage-backed securities (MBSs) that fell to a very low point when people could not pay their mortgages back. As a result, many institutions were heavily invested in these securities.
Many institutions invested in the MBSs went under and did not open back up for business. These events led to a global financial crisis of 2008-2009. The housing market took many years to recover after these events unfolded.
The effects of the Great Recession were immense; many people lost their jobs, homes, and much more. In addition, during this time, suicide rates increased in the United States and other countries.
Summary
Economic cycles occur naturally in most countries with established economies. These cycles are majorly due to supply and demand levels that many factors can cause. Therefore, business cycles are vital for the health and growth of economies.
Economies must go down to grow higher. Four phases can be thought of when analyzing economic cycles. Peak, trough, expansion, and contraction periods are most desirable.
A transition from expansion to contraction will lead to a peak, and a shift from contraction to expansion will lead to a trough. Business is excellent during expansion, and families are doing primarily well. Unemployment rates are usually low, and GDP is generally growing.
It can lead to bear markets in the stock market and recession. Companies will issue a hiring freeze, and unemployment rates will rise. As a result, GDP will decrease over time.
The cycles affect everyday lives; many individuals' lives will become more challenging during contraction. For example, during times of contraction, the prices of goods and services will begin to rise, as products such as fuel. As a result, companies will have to pay more; thus, they have to charge more.
In general, business cycles are healthy for the economy. They allow retail and institutional investors to gain investment in lower areas and our economy to cool off when it gets too hot. This prepares it to travel higher in the future.
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