Boom and Bust Cycle, Causes, History, and How to Protect Yourself

The boom and bust cycle is the alternating phases of economic growth and decline. It's another way to describe the business cycle or economic cycle. According to the Federal Reserve Bank of Richmond, they appear to be inevitable. But the more you understand their phases, causes, and history, the more you can protect yourself.

The boom and bust cycle has the same four phases as the business cycle.

In the boom phase, growth is positive. If gross domestic product growth remains in the healthy 2% to 3% range, it can stay in this phase for years. It accompanies a bull market, rising housing prices, wage growth, and low unemployment.

The boom phase doesn't end unless the economy is allowed to overheat. That's when there's too much liquidity in the money supply, leading to inflation. As prices rise, irrational exuberance takes hold of investors. The GDP growth rate grows above 4% for two or more quarters in a row. 

The end of the boom or expansion phase is the peak. According to the National Bureau of Economic Research, it is the inflection point where the economy stops expanding.

The bust phase is the contraction phase of the business cycle. It is brutish, nasty, and mercifully short. It rarely lasts more than 18 months. GDP turns negative, the unemployment rate is 7% or higher, and the value of investments falls. If it lasts more than three months, it's a recession. It can be triggered by a stock market crash, followed by a bear market.

A stock market crash can cause a recession. As stock prices fall, everyone loses confidence in the state of the economy. When investors don’t feel confident about the future outlook, they pull out their investments. They cut back business activities such as purchasing, hiring, and investing.

The trough is the inflection point where the economy stops contracting and begins to expand.

Three forces combine to cause the boom and bust cycle. They are the law of supply and demand, the availability of financial capital, and future expectations. These three forces work together to cause each phase of the cycle.

In the boom phase, strong consumer demand is the leading force. Families are confident about the future, so they buy more now. They know they'll get better jobs, and their home values and investments will increase in value. This demand means companies have to boost supply, which they do by hiring new workers. Capital is easily available, so consumers and businesses alike can borrow at low rates. That stimulates more demand, creating a virtuous circle of prosperity.

If demand outstrips supply, the economy can overheat. Also, if there's too much capital chasing too few goods, it causes inflation. When this happens, investors and businesses try to outperform the market. They ignore the risk of bad investments to achieve gain. 

In the bust phase, the main force is plummeting expectations about the future. Investors and consumers get nervous when the stock market corrects or crashes. Investors sell stocks. They buy safe-haven investments that traditionally don't lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral. If it continues, it can lead to an economic depression.

The bust phase stops when supply lowers prices enough to stimulate demand. That happens when prices are so low that those investors that still have cash start buying again. Confidence can be restored more quickly with central bank monetary policy and government fiscal policy. 

The best way to protect against the boom and bust cycle is to rebalance your investment portfolio once or twice a year. It will automatically make sure you buy low and sell high. For example, if commodities do well and stocks do poorly, your portfolio will have too high a percentage of commodities. To rebalance, you'll sell some commodities and buy some stocks. That forces you to sell the commodities when prices are high and buy the stocks when prices are low.

Know the causes of recession so you can hedge your finances before it happens. Follow the top five leading economic indicators. Look out for signs such as high interest rates. That could lead to declining home prices as sellers offset the higher mortgage costs. Another significant sign is a decline in durable goods orders.

Asset bubbles can be just as dangerous. There have been seven since 2005. They occurred in housing, oil, gold, U.S. Treasuries, the stock market, the U.S. dollar, and bitcoin. Study them to make sure you don't get caught up in the next one.

The NBER provides the history of boom and bust cycles. It determines when each of the four phases occurred with economic indicators. These include GDP statistics, employment, real personal income, industrial production, and retail sales. 

Since 1929, there have been 28 cycles. On average, the booms last 38.7 months and the busts last 17.5 months. Data on the NBER cycles go as far back as 1857.  Historical fed funds rates go back to 1971.