Business Cycle Stages and Market Behavior

Understanding the Business Cycle

The business cycle represents the natural rhythm of economic activity, alternating between periods of growth and contraction. For investors, understanding where the economy sits within this cycle can inform asset allocation decisions and set realistic expectations for portfolio performance.

The National Bureau of Economic Research (NBER), the official arbiter of US recessions, defines business cycles as the "recurring sequence of expansions and contractions in aggregate economic activity." Since 1945, the US has experienced 12 complete business cycles, with expansions averaging roughly 64 months and contractions averaging about 11 months.

This article explains the four primary phases of the business cycle, how major asset classes typically behave in each phase, and the key indicators investors can monitor to identify transitions.

The Four Phases of the Business Cycle

Phase 1: Expansion

Expansion is the growth phase of the cycle. During this period, Gross Domestic Product (GDP) rises, unemployment falls, and corporate earnings generally increase. Consumer and business confidence improves, credit conditions ease, and spending accelerates.

Key Characteristics of Expansion:

• GDP growth typically ranges from 2% to 4% annually
• Unemployment rate declines, often dropping below 5%
• Industrial production increases
• Retail sales and consumer spending rise
• Business investment in equipment and structures grows
• Credit conditions loosen as banks compete for lending business

The expansion phase can last anywhere from two to ten years. The longest expansion in US history ran from June 2009 to February 2020, lasting 128 months. During expansions, inflationary pressures typically build gradually as labor markets tighten and capacity utilization rises.

Phase 2: Peak

The peak marks the transition point where economic activity reaches its maximum level before beginning to decline. At the peak, the economy operates at or near full capacity, unemployment sits at cycle lows, and inflationary pressures often intensify.

Key Characteristics of the Peak:

• GDP growth begins to decelerate
• Unemployment reaches cycle lows (often below 4%)
• Capacity utilization approaches 80% or higher
• Wage growth accelerates, putting pressure on corporate margins
• Interest rates often rise as the Federal Reserve combats inflation
• Credit growth may become excessive

Peaks are notoriously difficult to identify in real time. The NBER typically does not declare a peak until 6 to 12 months after it has occurred, using a range of economic indicators to make its determination.

Phase 3: Contraction (Recession)

Contraction is the declining phase of the cycle, often called a recession when it becomes severe or prolonged. The NBER defines a recession as "a significant decline in economic activity that is spread across the economy and lasts more than a few months."

Key Characteristics of Contraction:

• GDP declines for two or more consecutive quarters (though this is not the official definition)
• Unemployment rises, often increasing by 2 to 4 percentage points
• Industrial production falls
• Retail sales and consumer spending decline
• Business investment contracts
• Credit conditions tighten as banks become more cautious

Since 1945, US recessions have lasted an average of 11 months, though they can range from 6 months (the 1980 recession) to 18 months (the 2007-2009 Great Recession). The COVID-19 recession of 2020 was the shortest on record at just two months.

Phase 4: Trough

The trough represents the lowest point of economic activity before recovery begins. At the trough, economic indicators stop declining and begin to stabilize, setting the stage for the next expansion.

Key Characteristics of the Trough:

• GDP stops declining and begins to stabilize
• Unemployment reaches its cycle peak (often lagging the trough by several months)
• Interest rates typically sit at cycle lows
• Inventories have been drawn down
• Pessimism reaches extreme levels
• Early signs of credit thawing appear

Like peaks, troughs are identified retrospectively by the NBER. Investors often do not recognize a trough until well after the recovery has begun.

Asset Class Behavior Across the Cycle

Different asset classes tend to perform distinctly during each phase of the business cycle. While these patterns are not guaranteed and can vary significantly across cycles, understanding historical tendencies can help investors set expectations.

Stocks

Expansion: Equities typically perform well during expansions, particularly in the early and middle stages. Corporate earnings grow, and investor confidence supports higher valuations. Cyclical sectors like technology, industrials, consumer discretionary, and financials often lead.

Peak: Stock performance becomes more mixed at cycle peaks. While the economy remains strong, markets may become increasingly volatile as investors anticipate the coming slowdown. Defensive sectors like healthcare, utilities, and consumer staples may begin to outperform.

Contraction: Stocks generally decline during recessions, though the severity varies widely. The S&P 500 has fallen an average of approximately 30% during bear markets associated with recessions since 1950. However, markets often bottom before the recession ends.

Trough: Equities typically begin to recover before economic data improves, often rallying sharply off trough levels. The first year of a new expansion has historically produced above-average stock returns.

Bonds

Expansion: Government bonds often underperform during expansions as rising interest rates push prices lower. High-yield corporate bonds may perform well as credit quality improves and default rates decline.

Peak: Bond performance becomes more nuanced at the peak. If the Federal Reserve is raising rates aggressively to combat inflation, bond prices may fall. However, expectations of an approaching recession can begin to support Treasury prices.

Contraction: High-quality government bonds typically perform well during recessions as investors seek safety and the Federal Reserve cuts interest rates. Treasury bonds gained an average of approximately 8% during the six recessions from 1980 to 2020. Corporate bonds, especially high-yield, may underperform as default risk rises.

Trough: Bond performance depends heavily on Federal Reserve policy. If rates have been cut significantly, bonds may offer limited upside. However, credit spreads often tighten as the recovery begins, benefiting corporate bonds.

Commodities

Expansion: Industrial commodities like copper, oil, and lumber typically rise during expansions as demand increases. The copper price is sometimes called "Dr. Copper" because of its perceived ability to diagnose economic health.

Peak: Commodity prices may reach cycle highs as demand remains strong while supply constraints emerge. Energy prices in particular can spike at cycle peaks.

Contraction: Commodities generally decline during recessions as industrial demand falls. Oil prices, for example, dropped approximately 70% during the 2008-2009 recession. However, precious metals like gold may perform well as investors seek safe-haven assets.

Trough: Commodity prices typically stabilize at the trough and begin to recover as industrial demand returns.

Asset Class Performance Summary by Cycle Phase

Leading, Lagging, and Coincident Indicators

Economists categorize economic indicators based on their timing relative to the business cycle:

Leading Indicators

Leading indicators tend to change direction before the overall economy, making them valuable for anticipating cycle transitions. The Conference Board publishes a widely followed Leading Economic Index (LEI) that combines ten components:

1. Average weekly hours in manufacturing
2. Average weekly initial claims for unemployment insurance (inverted)
3. Manufacturers' new orders for consumer goods and materials
4. ISM Index of New Orders
5. Manufacturers' new orders for nondefense capital goods excluding aircraft
6. Building permits for new private housing units
7. S&P 500 stock price index
8. Leading Credit Index
9. Interest rate spread (10-year Treasury minus federal funds rate)
10. Average consumer expectations for business conditions

When the LEI declines for three or more consecutive months, it often signals an approaching recession. The yield curve spread (10-year Treasury minus 3-month Treasury or 2-year Treasury) has been particularly reliable, inverting before each of the last eight US recessions.

Coincident Indicators

Coincident indicators move in tandem with the overall economy and help confirm the current phase of the cycle:

• Nonfarm payroll employment
• Industrial production
• Personal income less transfer payments
• Manufacturing and trade sales

The Conference Board also publishes a Coincident Economic Index combining these four measures.

Lagging Indicators

Lagging indicators change direction after the economy has already shifted, confirming that a phase transition has occurred:

• Average duration of unemployment
• Ratio of inventories to sales
• Change in labor cost per unit of output
• Average prime rate charged by banks
• Commercial and industrial loans outstanding
• Ratio of consumer installment credit to personal income
• Consumer price index for services

Lagging indicators are less useful for timing but provide confirmation of cycle turning points.

The NBER Recession Dating Methodology

The NBER's Business Cycle Dating Committee determines the official start and end dates of US recessions. Rather than relying solely on the popular "two consecutive quarters of declining GDP" rule, the committee examines a range of monthly indicators:

• Real personal income less transfers
• Nonfarm payroll employment
• Real personal consumption expenditures
• Wholesale-retail sales adjusted for price changes
• Industrial production
• Household employment from the survey

The committee looks for a "significant decline in economic activity that is spread across the economy and lasts more than a few months." This approach captures recessions that may not meet the simple GDP rule while avoiding false signals from temporary economic disturbances.

Because the committee waits for sufficient data, official recession dates are typically announced 6 to 12 months after the fact. For example, the February 2020 peak was not announced until June 2020, and the April 2020 trough was not announced until July 2021.

Practical Monitoring for Investors

Investors seeking to track the business cycle should establish a regular monitoring routine:

Weekly:

• Initial jobless claims
• Mortgage applications
• Gasoline demand

Monthly:

• Employment report (nonfarm payrolls, unemployment rate)
• ISM Manufacturing and Services PMI
• Retail sales
• Housing starts and building permits
• Consumer Price Index (CPI)
• Conference Board Leading Economic Index

Quarterly:

• GDP growth rate
• Corporate earnings
• Federal Reserve Summary of Economic Projections

Investor Takeaways

Understanding the business cycle does not mean attempting to time the market precisely. Instead, cycle awareness helps investors:

1. Set realistic expectations: Different phases produce different return profiles across asset classes.

2. Maintain perspective during downturns: Contractions are normal and temporary parts of the economic rhythm.

3. Avoid panic at the wrong time: Markets often bottom before economic data improves, making it costly to sell during contractions.

4. Consider sector positioning: Cyclical sectors tend to outperform early in expansions, while defensive sectors may hold up better during contractions.

5. Monitor leading indicators: Tracking a handful of key indicators can provide early warning of potential phase transitions.

The business cycle has repeated throughout economic history, and understanding its phases is foundational knowledge for any long-term investor. While the timing and severity of each cycle varies, the underlying pattern of expansion, peak, contraction, and trough continues to shape investment returns across asset classes.