Business Cycles

The term business cycle (or economic cycle) refers to fluctuations in economic activity, due to changes in economic growth and business conditions. The analysis of the business cycle is one of the primary interests of analysts, stock traders and investors, who try to identify the state of the economy and more importantly where it is heading in order to decide about their investments accordingly.
 
A business cycle is usually identified as a sequence of four phases:
 

1. 1. Expansion: A speedup of economic activity. Stock markets usually rise strongly as business conditions improve and corporate earnings rise. As overall confidence improves, riskier assets such as small stocks and high yield corporate bonds outperform as well.

 

2. 2. Peak: The upper turning point of a business cycle. During the peak phase, stock markets may rise but volatility rises as well. Corporate earnings and optimism reach their highest level. It is not advised to buy stocks during the peak phase because most of the times, stock prices are well above their fundamental fair values.

 

3. 3. Recession: A slowdown of economic activity. The stock market usually falls significantly with high volatility. Business conditions get worse and corporate earnings fell considerably.

 

4. 4. Trough: The lower turning point of a business cycle, where a recession turns into an expansion. Stock markets start to rise in the later stages of the recession due to favorable fiscal policy and monetary actions. The stabilization of business conditions increase the demand for stocks and many investors identify investment opportunities in undervalued stocks.

 
When the economy is heading to an undesirable direction, economists and government officials may apply fiscal as well as monetary policy tools to change the course of the economy and improve the business environment. Fiscal policy is conducted by the government which is responsible for changes in taxes and government spending. A decrease in taxes or an increase in government spending will stimulate economic activity. Monetary Policy on the other hand, is conducted by the central bank of the country. The central bank can decrease interest rates, an action that will improve credit expansion and investment. This in turn will increase the product of the economy. The longest U.S. economic expansion lasted 120 months and the longest economic recession lasted 65 months.
 
The most popular indicator of economic activity is the GDP growth. However, business cycles cannot be fully captured by the GDP growth. The problem is that GDP is published quarterly and is revised regularly, making predictions about the business cycle difficult. Rather, it is a combination of indicators that reflects the health of the economy in more detail. Therefore, analysts rely on indicators such as unemployment, consumer confidence, industrial production, personal income and retail sales in order to get a broader picture of the economy.
 
The above description of the typical business cycle may make stock trading and investing sound easy. Buy stocks once in a trough and buy bonds once in a peak. However, market timing may be a trap for investors, because each cycle exhibits different characteristics. Moreover, stock traders are often afraid of buying too soon or selling too late and very often miss opportunities that are presented to them. Therefore, careful and periodic analysis of economic indicators is critical for successful asset allocation and stock trading.
 
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