Understanding The Business Cycle

With the economy running through recessions, bubbles, and all sorts of other terms that get overused by the media it's sometimes easy to forget that normal economies go through a cycle. By understanding what each point in the business cycle is, you should be better able to understand where our current market conditions lie and be able to take action investing to profit at the right time.

Expansion

During the course of normal business, the economy is expanding upwards. During the expansion phase of the cycle, there are strong demand for jobs, inflation is controlled, and there is an increase appetite for products, which are being served by companies growing their capacities.  In general, profits are rising for companies and the employees and the Gross Domestic Product (GDP) of the economy is growing.

Peak

The peak of the business cycle is when the demand from expansion outweighs the supply.  In this scenario, it becomes difficult to find employees for the jobs needed.  As a result, wages increase which drives up inflation.  With the increased inflation interest rates begin to increase and bond prices are depressed.  With the increase in interest rates, companies can no longer finance expansion, consumers reduce spending on big ticket items and mortgages.  Stock markets begin to fall after the peak has been reached.

Contraction

The contraction period is most common referred to as a recession.  This occurs when there is a decrease in the real GDP of the economy.  Often times during the business cycle a contraction occurs without a recession occurring, only slowed growth.  However as the 2008/09 recession has proven that there is still the possibility for large recessions.  Since consumer spending has decreased, the business inventories have increased and profits decrease.  The number of unemployed rises.  Consumers begin spending less and saving more.

Trough

At the lowest point in the contraction business have too much supply and not enough demand so prices fall and so do employee wages due to the high unemployment.  Because of these factors inflation begins to fall.  Interest rates follow inflation downwards and cause bond prices to rise.  The very bottom is reached once consumer that were normally buying items during expansion have been enticed back into spending due to the low interest rates.  The stock market also has a lot of bargain prices and will spark a rally from the trough.

Recovery

The recovery is a strong increase in demand and spending that will generally bring the economy back to the level of the peak that had previously occurred.  Production begins to increase however most businesses are still anxious about hiring back to their full levels of employment during the peak so unemployment remains high.  As a result employee wages remain depressed and inflation continues to languish.  However once it has been established that the economy has reached back to the levels of the previous peak another expansion is occurring and companies will begin investing in growth anew.

The Money Cycle Recap

Through the cycles we can see that there is money to be made at any point however picking peaks and troughs are the ideal scenario for buying and selling the stock market.  During the peak period euphoria is present in the market and you need to be able to see through that and sell your stocks and begin loading up on bonds.  Then the recession hits and bonds begin to rally.  Then in those darkest of days you sell your bonds and load up on all the bargains present in the stock market and ready yourself for the recovery and next expansion.  Investing can be a tricky field but understanding some of these basic principles will help keep you grounded in your investing decisions.