So many things in life ebb and flow, including economic activity. Poetic as it is, the economic cycle can be stressful if you don't understand what's happening as it makes its way through the ups and downs. Read on to learn more about this process.
What is the economic cycle?
The economic cycle is a process through which economic activity grows and shrinks in a relatively predictable pattern. Although the length of each period in the cycle isn't all that predictable, the pattern repeats again and again, so we can at least pinpoint where we are in it.
Factors like gross domestic product (GDP), interest rates, total employment, and consumer spending are examined and compared to one another to determine at what point in the cycle we happen to be. Expansion is a great time for businesses to grow and thrive, but contraction helps to consolidate and refocus economic activity. Both have their necessary place.
What are the stages of the economic cycle?
There are four basic stages of the economic cycle:
- Expansion. During expansion, the economy goes through rapid growth, with production increasing and consumer spending rising. Interest rates are often low, which allows for a flow of cheap money that can sometimes lead to inflation.
- Peak. The peak of the economic cycle is the point at which economic growth has hit its maximum rate. Economic indicators may stabilize for a period, but soon start to reverse.
- Contraction. A contraction, or correction, is the next phase, as growth begins to slow due to a decrease in demand and sometimes oversaturated markets that push prices lower. Too deep of a contraction can lead to depression, which isn't great for anybody.
- Trough. When consumer spending and incomes are stagnant, and the economy is growing as slowly as it will, you're in the trough. Fortunately, with effort, recovery is possible and has so far happened in every economic cycle.
How are economic cycles managed?
Economic cycles are managed by governments using monetary policy tools like interest rate changes, or alterations to deficit spending. Taxation is another tool to cool off a too-hot market, which helps to reduce spending and can create a budget surplus that can be used for all kinds of things, including paying down government debt.
Debt accrual due to deficit spending can help spark a new expansion period in an economic cycle by getting money flowing again. Taxes or interest rates may be changed to encourage business investment, which can cause a slow expansion of the economy over time.
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Why do economic cycles matter to investors?
For long-term investors, economic cycles matter a lot less than they do for investors with shorter investment time horizons. Foolish investors hold their investments through economic cycles because they're good businesses that can go the distance, rain or shine.
But we're all still people, and these rises and falls in the economy can have massive effects on our portfolios. Sometimes, it's important to understand where we are in the economic cycle so we can choose investments that can produce well even in a downturn, like utilities or consumer staples. Sometimes, economic cycles allow us to shop for bargains when the economy is cooling, including certain types of real estate investment trusts (REITs) or housing stocks.
Understanding economic cycles and where we are in them can help you make buying decisions that take advantage of the normal rises and falls in various cyclical industries. Although we still believe in dollar-cost averaging and small, incremental investments over time, when you can get stocks you were already going to buy at a discount, there's nothing wrong with that.
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