Understanding Business Cycles

A Clear Guide to Economic Fluctuations for CFA Candidates

1

Overview of the Business Cycle

The business cycle describes the natural rise and fall of economic activity over time. Though cycles vary in length and intensity, they follow a predictable pattern that helps investors and policymakers anticipate shifts in the economy.

Key Components

Expansion

Period of rising GDP, income, and employment.

Contraction

Period of falling GDP, income, and employment (often called a recession if prolonged).

Peak

Highest point of economic activity—end of expansion, start of contraction.

Trough

Lowest point of economic activity—end of contraction, start of recovery.

The Four Phases

Each phase has distinct economic conditions and investment implications:

Phase 1: Recovery (Trough)

Economic Conditions:

  • Economy hits its lowest point.
  • Activity begins to rebound.
  • Confidence slowly returns.

Investor Behavior: Low interest rates and improving outlook make cyclical stocks attractive.

Phase 2: Expansion

Economic Conditions:

  • Strong growth in GDP, jobs, and spending.
  • Output exceeds long-term potential.
  • Prices and interest rates rise.
  • Risk of "overheating" increases.

Investor Behavior: Equities perform well; business confidence is high.

Phase 3: Slowdown (Peak)

Economic Conditions:

  • Growth begins to decelerate.
  • Output is at its highest level.
  • Inflation may peak or start to ease.
  • Optimism remains, but caution grows.

Investor Behavior: Smart money shifts toward bonds; equity valuations are stretched.

Phase 4: Contraction

Economic Conditions:

  • GDP, employment, and spending fall.
  • Output drops below potential.
  • Business confidence collapses.
  • Recessionary conditions emerge.

Investor Behavior: Flight to safety—investors favor bonds and defensive stocks (e.g., utilities, consumer staples).

Types of Business Cycles

Classical Cycle

Based on absolute GDP levels—contraction = falling GDP.

Growth Cycle

Measures deviations from long-term trend—downturn = growth below trend (even if positive).

Growth Rate Cycle

Focuses on changes in the growth rate—downturn = slowing growth.

2

The Credit Cycle

The credit cycle reflects how easily businesses and consumers can borrow money—and it closely mirrors the business cycle.

During Expansions

Lenders loosen standards—credit is abundant and cheap.

During Contractions

Lenders tighten standards—credit becomes scarce and expensive.

Why it matters: Easy credit can inflate asset bubbles (e.g., housing, stocks). Monitoring the credit cycle helps anticipate turning points in the broader economy.

3

How Firms Behave Through the Cycle

Corporate decisions on investment, hiring, and inventory provide real-time signals about the economy's direction.

Capital Spending

Firms invest in new equipment or facilities when:

  • They expect strong future demand.
  • Current profits and sales are rising.
  • Existing capacity is near full utilization.

Workforce & Cost Management

Early in a downturn, firms delay layoffs. As the contraction deepens, they:

  • Reduce advertising and discretionary spending.
  • Liquidate excess inventory (often at discounts).
  • Eventually cut jobs to preserve cash.

Inventory-to-Sales Ratio

This key metric shows how much inventory companies hold relative to sales:

Rising ratio: Sales are slowing—potential sign of an approaching contraction.

Falling ratio: Sales are outpacing production—may signal future output increases.

4

Tracking the Cycle with Economic Indicators

Analysts use three types of indicators to identify where we are in the business cycle.

Indicator Types

Indicator Type Timing Examples
Leading Change before the economy Stock prices, building permits, jobless claims, consumer sentiment
Coincident Change with the economy Payroll employment, industrial production, personal income
Lagging Change after the economy Unemployment rate, CPI inflation, corporate profits

Composite Indicators

Single indicators can be noisy—so analysts combine them into reliable indexes:

Conference Board LEI

Leading index for the U.S. economy.

OECD CLI

Tracks turning points globally using the growth cycle framework.

Tendency Surveys

Measure business and consumer sentiment—powerful leading signals.

Modern Tools: Big Data & Nowcasting

Big Data

Real-time data from e-commerce, shipping, and payments offer faster economic insights.

Nowcasting

Estimates current-quarter GDP using high-frequency data (e.g., Atlanta Fed's GDPNow model).