Written by Justin Kuepper. Updated by TraderHQ Staff.
Predicting the stock market is notoriously difficult, but there are some well-defined and predictable patterns that arise from the chaos. Business cycles are a great example of these predictable patterns, arising from the inherent boom-bust nature of capitalist economies. Of course, there are many well-known variations of these cycles, such as the so-called January Effect or longer-term stock market cycles.
In this article, we’ll take a look at business cycles and how they impact the financial markets, as well as how traders can track them to maximize their returns.
What Is the Business Cycle?
Business cycles arise from changes in economic growth within an economy. For example, the U.S. stock market has gone through several business cycles over the past few decades highlighted by events like the tech bubble in 1999/2000, the subprime mortgage crisis in 2007/2008, and the COVID-19 pandemic in 2020. These types of events cause the peaks and troughs within the cycle, which is also called the economic or boom-bust cycle.
Business cycles don’t necessarily mean that market downturns completely erase the progress made during market upturns. The U.S. has realized long-term growth in its gross domestic product, but temporary downturns occur along the way. These downturns consist of peaks and troughs within the long-term bullish trend.
The changes in economic growth that cause business cycles are driven largely by liquidity in the financial system. For instance, excess liquidity in the U.S. financial system was a large contributing factor to the subprime mortgage crisis. Low interest rates made housing affordable to almost anyone, while investors looking for yield were willing to take on excessive risks when it came to lending.
Stages of Business Cycles
Business cycles can be broken down into various stages, according to the U.S. National Bureau of Economic Research. For traders, each portion of a business cycle presents different opportunities to profit given that the dynamics tend to favor certain industries or asset classes. For example, market contractions tend to favor defensive industries like consumer staples.
Expansion
Expansions occur between the trough and peak of a business cycle and are characterized by an increase in production and prices, which are powered by low interest rates set by central banks. These periods tend to favor industries like technology, financials, and capital goods, which benefit from increased leverage relative to safer and more traditional industries.
Peak
Peaks occur at the top of a business cycle and are characterized by stock market volatility, multiple bankruptcies of major firms, and/or lower consumer sentiment, driven by the realization of excesses and the spread of fear throughout the financial market. These periods tend to draw capital into energy and precious metals sectors, which provide investors with a bit of a safe-haven.
Contraction
Contractions, or recessions, occur between a peak and trough of a business cycle and are characterized by falling production and prices, as well as decreasing or stagnant income growth. These periods tend to draw investors out of safe-havens and into more conservative industries like consumer non-cyclicals and utilities, which often have a dividend component and low beta coefficients.
Trough
Troughs, or recoveries, occur at the bottom of a business cycle and are characterized by a slow recovery in stock prices, driven by the fall in prices and incomes that form the beginning of an expansion. These periods tend to favor turnaround industries like financials and consumer cyclicals, which are riskier than many other sectors but not quite as aggressive as technology or pharmaceutical sectors.
3 Ways to Trade Business Cycles
There are many different ways that traders can profit from business cycles, ranging from simply moving money into favorable industries to using specific strategies. While many of these strategies may seem straightforward, determining where an economy is within a business cycle can prove very difficult on its own, which means that sector rotation is half art and half science in the end.
Simple Sector Rotation
Traders can improve their risk-adjusted returns by focusing on certain sectors during a given business cycle. Historical data shows that long-term performance can differ significantly between simply investing in the market versus using sector rotation strategies. While the market has eliminated some inefficiency, many of these trends still exist today.
Elliott Wave Cycles
The Elliott Wave Principle was developed by Ralph Nelson Elliott in order to analyze financial market cycles and forecast trends by identifying extremes in investor psychology. The patterns described by the principle can be accurately overlaid with business cycles in many cases, helping technical traders improve their market timing and ultimately enhance their risk-adjusted returns.
Longer-Term Stock Market Cycles
Various analysts have studied longer-term stock market cycles that connect major market events over decades. These longer cycles can provide a macro framework for understanding where we are in the broader economic picture, though they require patience and a long-term perspective to implement effectively.
The Bottom Line
Business cycles are a natural part of the boom-bust nature of capitalism, but they can also provide opportunities for traders. By knowing which industries are favored within each business cycle, traders can improve their long-term risk-adjusted returns. Other strategies like Elliott Waves can help improve market timing within those cycles in order to further enhance profits and limit losses.
Frequently Asked Questions
How do I know which phase of the business cycle we’re currently in?
Several economic indicators can help identify the current phase: GDP growth rates, unemployment trends, yield curve shape, consumer confidence, and manufacturing data. The National Bureau of Economic Research (NBER) officially declares recessions, though typically with a delay. Leading indicators like the yield curve often signal transitions before they’re officially recognized.
What sectors perform best during recessions?
Defensive sectors typically outperform during recessions. These include consumer staples (food, household products), healthcare, and utilities—businesses people need regardless of economic conditions. These sectors usually have lower beta, meaning they decline less than the overall market during downturns. Dividend-paying stocks in these sectors can also provide income while waiting for recovery.
Is it possible to time the market using business cycles?
While understanding business cycles can inform investment decisions, precisely timing market tops and bottoms is extremely difficult. A more practical approach is to gradually adjust portfolio allocations as economic conditions evolve rather than making dramatic all-or-nothing shifts. Many investors use business cycle analysis to inform sector weights within an always-invested strategy.