The Business & Market Cycle
You might have heard the phrase ‘the business cycle,’ but what does that really mean? In the simplest terms, it refers to the cycles an economy goes through from expansion, to peak, to contraction, to trough, to expansion again. There’s certainty a lot more to it that I will get into, but the business cycle is just a way to reference this process. As is the case with many phenomena, there are ebbs and flows to economies and patterns within that process that can help you identify what stage of the cycle the economy is in. In doing so, investors can better predict some of the macro trends driving markets on a monthly or yearly basis and position themselves in the appropriate sectors or asset classes as the cycle unfolds. This probably won’t help you trade on a day-to-day basis, but it will clarify some of the secular trends in markets and natural economic forces moving the economy, so it should be useful regardless of any actual trading ideas it may or may not give you as it will get you thinking about the macro landscape in a more practical way. Macroeconomics can be thought of as discovering a story currently underway and fitting it into cycles and price action. If you have the right story, you can identify the right cycle and slowly piece together all the moving parts to create an investment plan consistent with that larger macro direction.
Now, before I dive into the market element of these cycles, let me better explain each part of the business cycle and how it operates starting with the expansion.
Expansion
The expansion is the phase of the cycle where the economy is emerging from a recession or low point of economic activity. This is the most desirable state of the economy as businesses are steadily growing, profits are climbing, unemployment is falling, and the market is performing well. This period also signals an increase in consumer buying, investing, and overall demand that translates to higher GDP. In other words, it’s the upswing of the economy where everything seems to be improving.
Peak
The peak is the sate of the cycle where the expansion has arguably gone too far and the economy is overheating. In this stage, companies might be expanding recklessly from an over abundance of confidence and cheap credit, investors and consumers might also be struck with overconfidence and bad spending habits, and inflation is starting to become an issue. Peaks are often referred to as the euphoric phase when economies and markets extend beyond their fundamentals by growing too accustomed to constant growth and acceleration. This overextension inevitably leads to the next phase.
Contraction
After a red hot economy catches up with reality, it begins to contract. This signals an economic slowdown where business declines, credit is less abundant, investor and consumer confidence fade, unemployment rises, and markets enter a bear market. This might seem similar to what many call a pullback, but a true contraction is an economic decline for at least two quarters. Pullbacks usually imply the peak is still to come, but a contraction would be a clear departure from the peak and the start of a prolonged downturn in the economy.
Trough
Much like a peak for every expansion, there is a bottom or trough for every contraction. This phase can be thought of as the point when economic activity is at its lowest, unemployment its highest, and markets finally reverse course from their long downtrend. Once this pivot from the low point occurs, the economy is considered to be in its expansion phase again as economic activity is, once again, in a prolonged uptrend and the cycle start all over.
MARKET CYCLES
Now that we have a general idea of this pattern economies repeat, let’s outline how this might look in the actual market as an investor. The phases of the market are strongly related to the business cycle, but they don’t necessarily mirror each other. For the purpose of this article, you can think of them as occurring in tandem, but markets have a tendency to be a leading indicator and experience their phases sooner than the actual economy. That said, they go through very similar stages.
Much like the business cycle, the market cycle has four phases: accumulation, markup, distribution, and markdown. While these are more accurately thought of as macro phases, it’s important to note they are also fractal and occur on a smaller scale within shorter timeframes all throughout the market during the larger cycles. Keeping that in mind, let’s get into the first phase.
Accumulation
The accumulation phase occurs when investors think the worst is over and the economy or market is at or close to its trough. The trough is the most ideal buying opportunity because it’s when prices are at their lowest and you have the highest potential upside given the economy is just starting to expand. Smart investors like to accumulate at the lowest prices so this phase is usually a period of consolidation at a low point in price action.
Markup
The markup is the second wave of buying that occurs when the expansion is more clear and investors feel more confident they are buying into a growing economy and bullish market. At this point, it’s fairly clear the market is in an uptrend with investors piling in, which pushes price up once again to what is frequently its high point.
Distribution
The distribution phase is when prices are at their peak and early investors are looking to distribute their holdings to other investors who are late to the party and trying to chase prices, which is usually retail. This phase is often a time when price is balanced by buyers and sellers leaving and entering the market and generally comes in the form of consolidation. This doesn’t mean there aren’t large or volatile moves, but with a relatively balanced amount of old investors selling and new investors buying, price tends to go back and forth for a while. The distribution phase is not the stage to buy as the upward price movement is likely exhausted with little to no new buyers entering the market. The distribution phase is simply the period during which early investors take profits by selling to the new investors who will end up being the bag holders, which brings is to the last stage.
Markdown
After all the early investors have sold and new investors fade, we enter the last stage called the markdown or downtrend. With no new buyers entering the market, there is widespread selling that drives down price until all the sellers are eventually exhausted, the market bottoms, and we move back into the accumulation phase. Ideally, you will avoid holding any position through the entirety of the markdown phase, but, if you do, it might be in your best interest to hold on or add to your position if it looks like it could be headed back in the accumulation phase. Retail has a tendency to do the exact opposite of smart money by buying during the distribution phase and selling in the accumulation phase so try your best not to be one of those people and avoid capitulating at the very bottom of the markdown.
So those are the basic cycles of the market and while they paint a better picture for investors than the business cycle, they still don’t help all that much if you’re looking for some actionable information, so let’s dive a little deeper into some of the specifics and how one might position themselves as these cycles take place. However, before I get into these specifics, I just want to emphasize the market by no means follows any of this like a script and there will always be exceptions, contradictions, and opportunity in all areas of the market regardless of the cycle you find yourself in. There are general rules of thumb and areas of the market that make more sense for fundamental reasons at certain periods, but none of this will act as a panacea for investing or trading—it’s simply a sensible way to view and contextualize the market during larger economic trends. With those caveats out of the way, let’s start from recession and work our way up.
INVESTING THROUGH THE MARKET CYCLES
As a market emerges from a recession, it often leans on financial companies (banks, brokers, insurance companies, and the like) as interest rates are still favorable and good for business. Financial companies who make their money through loans and other forms of credit can experience a powerful combination of low rates that encourage more borrowing at the same time the economy is picking up, which also encourages more borrowing and can lead to a notable increase in profits.
When the expansion starts to become more clear to investors, the next transition is usually into the technology or growth sectors as businesses and investors throw money at new tech or speculative growth names on that initial upswing of the economy when debt and revenue are less of a concern.
As the economic recovery gathers momentum and has grown more obvious, investors will look to the consumer discretionary sector due to growing consumer confidence and spending. When an economy gets rolling, consumers buy more unnecessary goods, go out to eat more, and just spend more in general and all that spending usually translates to consumer discretionary names seeing a boost in earnings.
After all that increased spending hits the economy, investors will move to transportation, industrials, and basic materials. This is usually the midpoint of the growth stage represented by increased demand for raw materials following the increased demand in consumer products. All those products consumers are buying require materials to make so there is a delay in demand for materials and the transportation thereof after consumer booms that leads to more revenue and profits for those aforementioned sectors.
That growing demand for transportation and materials, in turn, draws investors and increased demand to the energy sector. Much like consumer goods need materials, materials need energy to be produced or transported. That lag in increased demand for energy frequently leads to a nice boost in earnings for energy companies and thus can be a good place to invest at this stage. Note how investors are always trying to stay one step ahead of the economy by finding the areas that should soon see an increase in demand as a consequence of previous areas of increased demand. Investing is all about seeing the flow of money and demand before they happen so always try to think three steps ahead like you’re playing a game of chess.
Once these stages of the growth part of the cycle play out and investors start to fear the beginning of an economic downswing, they will start to move to defensive sectors. These include utilities, consumer staples, health care, and other essential services. In other words, businesses that maintain steady demand in most economic conditions.
The first stage of this defensive transition usually begins with consumer staples (think groceries and basic household goods). Even during economic calamities, everybody presumably still buys things like food and toilet paper, so earnings will remain relatively unaffected and thus likely protect you against any serious market drawdowns.
Another sector investors find themselves in at the early stages of a recession is utilities. The economy may be struggling, but people will still be paying their water and electric bills so that sector, too, will be largely unaffected by economic contractions.
As a recession worsens, investors will look to diversify into other areas of the market like health care or the services sector, which includes things like waste management and labor staffing. As the previously mentioned sectors become oversaturated, finding alternative defensive areas of the market becomes more important so it’s useful to have a full list of possibilities like health care or services to expand into. Health care and essential services like the ones mentioned may not seem like great investments to some, but they’re usually not an expense consumers cut in hard times.
Truthfully, it doesn’t really matter what you invest in so long as it’s a company or industry that consumers and the economy don’t forgo in hard times. Just consider all of them and find the most appealing. Many of these sectors are somewhat interchangeable and really just offer you an opportunity to diversify into alternative areas of the market as more investors flock to other safe haven industries. All the sectors I’ve listed for defensive investing could be thought of as listed in descending order of safety, but it really depends on valuations and specific market circumstances, so lookout for all of them when you are in defensive mode and cycle out when you think they’re approaching over saturation.
After all these rotations into defensive investments come to an end and the expansion/accumulation phase is on the horizon, the cycle repeats and investors start all over.
As I mentioned before, this isn’t necessarily a playbook for tackling the market or a suggestion the market even follows this very detailed cycle, but it’s a sensible way to view how the market progresses that frequently does play out and, if nothing else, is at least an insight into how investors like to map the overarching trends throughout the market and business cycles. Markets evolve constantly and no cycle or element of a cycle is guaranteed to play out the way you think it should and there are always unique circumstance to consider that will change your investment calculus. So try to use all this as way to think about how markets transition from sector to sector just as much as an outline for what specific sectors investors might be looking toward throughout the cycles. Markets are always forward looking so thinking about how the economy, consumers, investors, and profits are all evolving is the best way to position yourself for all the future trends.