What the business cycle describes
The economy does not grow in a straight line. It grows in waves. Sometimes households, businesses, government and foreign buyers spend more, sometimes less. Output, jobs and incomes rise and fall with that demand. One full wave, from one expansion to the next, is what economists call a business cycle.
Mood plays a part that no statistic captures. Optimism feeds an expansion, pessimism deepens a contraction. That is one reason why cycles overshoot in both directions.
I first wrote about this topic in 2023 in German, for crypto investors back then. This version is for anyone who holds stocks and ETFs. The stages are the same.
The four stages
1. Expansion
The economy grows. Companies get more orders, hire and invest. Unemployment falls, usually with some delay. Because more people have work, they spend more. That keeps the expansion going on its own.
2. Peak
The economy runs at full speed. Many businesses work close to capacity. Demand is higher than what can be produced in the short run, so prices often rise faster. Central banks usually respond with higher interest rates. Loans get more expensive, investments pay off less. That slows things down.
3. Contraction
Demand and investment fall. Companies cut production and hire less. When the decline is significant, lasts for more than a few months and spreads across the economy, it is a recession. A popular rule of thumb calls two quarters of falling GDP in a row a recession. In the US, the official dates come from the Business Cycle Dating Committee of the NBER, which looks at many indicators at once, including jobs, incomes, spending and production.
4. Trough
The economy hits bottom. Unemployment is high and businesses run well below capacity. Central banks usually cut rates in this phase, and governments support demand. A trough that is exceptionally deep and long is called a depression. After the trough, the next expansion begins and the cycle starts over.
The lines between the stages are blurry. No cycle repeats the one before. The four stages are a model, not a schedule.
How long a cycle lasts
The NBER keeps a table of every US expansion and contraction since 1854. The averages:
| Period | Contraction | Expansion | Cycle, trough to trough |
|---|---|---|---|
| 1854 to 2020 | 17.0 months | 41.4 months | 58.4 months |
| 1945 to 2020 | 10.3 months | 64.2 months | 74.5 months |
Since 1945, contractions have become shorter and expansions longer. The averages hide large differences, though. The 2020 recession lasted two months. The financial crisis, from December 2007 to June 2009, lasted 18 months. The expansion in between ran for 128 months. The Great Depression lasted from August 1929 to March 1933, 43 months.
Four indicators for the current stage
Whether a contraction has started becomes official only months later. These four numbers show the direction earlier.
GDP. Gross domestic product measures everything a country produces. The Bureau of Economic Analysis publishes it every quarter. It is the most important number, but it arrives late and is often revised.
The Leading Economic Index. The Conference Board combines ten forward-looking data series into its Leading Economic Index, among them new orders, building permits, initial unemployment claims and consumer expectations. It tends to turn before GDP does.
Unemployment. Companies lay people off only when they are sure the orders will stay away. They hire again only when the expansion holds. That is why the job market reacts late. The Bureau of Labor Statistics publishes the unemployment rate every month. When it rises clearly, the contraction is usually already here.
The stock market. Stock prices reflect expectations, not the current state. That is why the S&P 500 itself is one of the ten components of the Leading Economic Index. Prices often fall while the economy is still growing and rise again while the news is still bad.
Why the stock market does not wait for the economy
Many investors wait for the end of a recession before they buy again. But they only see the end in the data, and the data comes late. By the time GDP grows again and unemployment falls, prices have often covered a good part of the recovery. The economy tells you where things were. The market trades where it thinks things are going.
For me, this means: I use economic data to understand the situation. I do not use it as a signal to buy.
Markets breathe
Every market moves in cycles. Stocks, real estate, commodities, even luxury watches. I like to compare it to breathing. When you breathe in, your chest rises. When you breathe out, it falls. Moves that go up too fast usually get corrected, and so do moves that go down too fast.
Prices cannot only go up. At some point investors want to take profits and sell. And a healthy company cannot keep falling forever. At some point it gets so cheap that buyers come in. With a solid business, a drop in price is followed by a rise over time, and a rise by a setback. That is normal and no reason for rushed decisions.
Thinking against the cycle
If you buy when everyone is excited, you usually pay a high price. If you sell when everyone is afraid, you usually sell cheap. Thinking against the cycle means recognizing the mood without letting it push you around.
Two feelings make this hard. One is the fear of missing out: when prices have risen for months, you want to be in, whatever the price. The other is panic during a crash. Both cost money. The volatility index shows how nervous the market is right now. On the page VIX today, I explain the market traffic light I calculate from it every day.
Why I do not try to guess the turning point
Almost nobody buys at the exact bottom and sells at the exact top. That is not a weakness, it is statistics. A euphoric phase can be the start of an even more euphoric one. A crash can be the start of an even deeper one. Turning points are only certain once they are behind us.
So I do not set myself the goal of hitting the turning point. I look at whether the mood is rather euphoric or rather fearful, and whether a company is worth its price. In a fearful phase, strong companies are often cheaper. A sports car at the price of a scooter, as long as the business behind it stays healthy.
Many investors solve the timing problem differently. They invest at fixed intervals, whatever the stage of the cycle. In a trough, the same amount of money then automatically buys more shares. You can check what that adds up to over several cycles with your own numbers in the ETF savings plan calculator.
What the cycle means for your portfolio
The business cycle explains why the stock market never only goes up. It does not tell you when to buy or sell. I take three things from it.
First: contractions are part of the deal. In the US, a cycle from trough to trough has taken a little over six years on average since 1945. If you know that, the next one will not catch you by surprise.
Second: the market is faster than the statistics. If you wait for official confirmation, you come late.
Third: preparation beats prediction. Knowing how long contractions have lasted helps you plan how much cash you keep and how long you can sit out a drop without selling. If you are thinking about living off your portfolio one day, my guide on living off your investments shows how much money that takes.