Many people who failed to recognize the state of the business cycle did not get out of the stock market before the Great Recession hit. Making matters worse, they feared to get back into the stock market at the beginning of an expansion cycle. That's the right time to do so.
While you can't time the market perfectly, you can improve your returns by getting better at reading the business cycle. You then can adjust your asset allocation to take advantage of the phases.
- The COVID-19 pandemic created a recession in February 2020.
- For 11 years after June 2009, the American economy was in an expansion phase.
- Watch these economic indicators to determine how the economy is doing: S&P 500, unemployment claims, consumer confidence index, housing sector.
- To manage your investment risks, stay invested in a diversified portfolio.
4 Phases of the Business Cycle
The business cycle has four phases.
- Expansion: The economy grows a healthy 2% to 3%. Stocks enter a bull market.
- Peak: The economy grows by more than 3%. Inflation sends prices up. There are asset bubbles. The stock market is in a state of "irrational exuberance." Talking heads announce that we are in a "new normal."
- Contraction: Economic growth slows but isn't negative, and employment declines. Stocks enter a bear market.
- Trough: The minimum point of contraction before the next expansion begins.
Current Business Cycle
The U.S. economy entered the contraction phase of the business cycle in February 2020.
In response to the COVID-19 pandemic, state governments closed non-essential businesses in March. By April, there were 23.1 million Americans unemployed, sending the unemployment rate to 14.8%.
Prior to that, the economy had been in the expansion phase for 11 years. The last trough was in June 2009. We have probably reached the trough for the 2020 recession and the Federal Reserve projects that unemployment will return to 5% in 2021.
The line chart below tracks the current business cycle according to the rise and fall of gross domestic product.
Expansion phases usually last five years or so. Even before the pandemic, many people were warning that a recession was just around the corner.
There were no warning signs that expansion had reached its peak. Instead of inflation, there were asset bubbles. In 2015, it was in the U.S. dollar. The weak demand for the euro contributed to a strong dollar. There was an asset bubble in housing prices right before the 2008 recession. Sometimes the irrational exuberance of a peak takes place in asset prices without generating overall inflation.
Economist John Kenneth Galbraith once said there are two types of economic forecasters: "Those who don't know and those who don't know they don't know." Here are some common indicators that indicate a recession even before it is officially declared.
This is a collection of 500 of the largest publicly traded stocks in the United States. The Dow Jones Industrial Average, by comparison, comprises only 30 stocks. As a result, the S&P 500 is a more thorough gauge of where the U.S. economy stands at any given time.
The number of workers claiming unemployment benefits topped 10% in 2009, but it dropped to less than 4% as of 2018. In general, rising unemployment rates are often seen as an indicator of trouble for the economy, and falling unemployment rates can be viewed as the opposite.
As with all potential indicators, though, look beyond the surface. For example, the unemployment rate measures only those people who either are working or are seeking work. Those who are not working by choice are not counted. According to the U.S. Bureau of Labor Statistics, the number of 16- to 24-year-olds who are not working because they are going to school has risen since 2009, while the unemployment rate has dropped.
The consumer confidence index measures how willing people are to make purchases in any upcoming 12-month period. A rating higher than 100 means that people plan to spend money, while a rating lower than 100 indicates that people are more likely to add to their savings and hold off on major purchases. The less willing people are to spend their money, the worse that can be for the economy.
An increase in new construction or rising values for existing homes can be positive indicators for the economy and the business cycle. On the flip side, if new construction slows, or existing home prices plateau, that can be a sign of trouble.
Remember that no single indicator should be viewed in a vacuum, and you should always look deeper than the headlines. For example, new construction might be slowing because tariffs made imported lumber more expensive. Other indicators might still project a strong economy. Some other potential indicators worth tracking include commodities prices, the consumer price index, and the producer price index.
How to Protect Yourself in Each Phase
Consult a certified financial planner when you want to buy specific funds or stocks. Here are some guidelines for what tends to do better in each phase of the business cycle:
- Contraction: Sit tight. If you haven’t sold stocks by the time the economy contracts, it’s probably too late. You could move some assets into bonds or cash, but keep some in stocks. You want to catch the rebound when it occurs. Most investors sell stocks when the contraction is already well underway. They don’t buy them until it’s too late. A recession or bear market usually lasts six to 18 months.
- Trough: Start adding stocks and commodities such as gold, oil, and real estate. They should be cheaper during a recession.
- Expansion: In the early stages of an expansion, small-cap stocks grow the fastest. Small companies are nimble enough to take advantage of a market turnaround. You can gain extra income with high-yield bonds. Add stocks and bonds from foreign developed and emerging markets. They hedge against a declining dollar. Emerging markets grow faster in the early stages of an upturn. For example, Brazil’s banks didn’t purchase subprime mortgages. The country's economy grew when the U.S. economy was in recession. Emerging markets are risky, but as the global economy improves, that risk is worth it. Later on in the expansion, add mid-cap and large-cap stocks. Larger companies do better in the late stages of a recovery.
- Peak: Sell stocks, commodities, and junk bonds. Increase the proportion of cash and fixed income. The safest are U.S. Treasury bonds, savings bonds, and municipal bonds. When interest rates are high, buy short-term bond funds and money market funds. As interest rates fall, a switch to corporate bonds provides a higher return with greater risk. Add gold until it's about 10% of your portfolio. It's a good hedge against inflation. It’s also the best protection during a stock market crash.
As you can imagine, it's incredibly difficult to sell stocks when everyone else is bragging about how much they're making. Timing the market is almost impossible. Instead, be conservative. Never have 100% of your investments in any one asset class.
Instead, make sure your investments are diversified. Gradually shift the proportion to stay in tune with the business cycle. Always work with a financial planner to make sure the allocation matches your personal goals.
The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.