Stages of the Business Cycle
Data on this page was last updated on May 18, 2023
The Stages of the Business Cycle
The business cycle is the Gross Domestic Product (GDP) fluctuation above or below the potential aggregate output of an economy that follows a natural contraction and expansion path.
No single indicator can gauge where we are at in the business cycle. However, there are interrelated cycles in consumer sentiment, monetary policy, credit conditions, and inflation, all within a business cycle. When we analyze these cycles together, we can gauge where the economy is in any particular economic cycle. This process can provide a rough but accurate idea of where the economy is currently positioned in the cycle.
To classify where we are in the business cycle, we need to organize it into consistent, meaningful stages. Our model breaks the business cycle into six stages, each with different macroeconomic themes and trends.
- Stage I - Recession
- Stage II - Recovery
- Stage III - Early Expansion
- Stage IV - Mid Expansion
- Stage V - Late Expansion
- Stage VI - Imminent Recession
Recession
A recession is what most investors and money managers fear. This is when productivity slows to a crawl because consumers are not consuming at the rate they usually would. This, in turn, causes corporations to cut costs, inventories are high, and discounting goods usually begins. Production slows or stops as existing goods are sold. Firms will also lay off employees to keep their margins aligned with their profitability goals.
This slowing productivity and lower earnings have a cascading effect on other issues that might cause more damage to the economy. If cutting costs is not enough to meet earnings expectations, the company’s stock will decline with the forward earnings expectations lowered. If cash flows become negative, then the company’s sustainability becomes in question, and defaults and bankruptcies occur. On an aggregate level, you will see credit conditions become tighter as banks are less willing to lend, slowing money supply and access to capital. Even health companies will feel the strain of credit spreads widening as they battle to maintain their existing debt obligations. This, in turn, causes equity prices to decline throughout the entire market.
Recovery
When all seems lost, the economy will find a point where consumers stop slowing and start to maintain their new lifestyle. Inflation is falling as it is no longer a threat to the economy. Industrial production and capacity utilization will reverse course and bottom. At the same time, unemployment is high and peaking. With inflation under control, monetary policy shifts to help the economy and the high unemployment by becoming accommodative, usually taking place quickly, and short-term rates drop dramatically.
This pivot in Federal Reserve policy will eventually ease credit conditions, and banks will lend funds to well-qualified borrowers. Firms will start to hire but at a slower pace. Companies will begin to fill their inventories, and earnings will rise with the increase in wages and money supply in the economy. The economy, at this point, is undoing the damage caused by the recession.
From an external perspective, the economy will look bad, but knowing what indicators to observe, a keen investor can take advantage of good companies priced below market value. This is where the term buy when “blood in the streets” comes from. The key is to identify this period.