The business cycle and who benefits when

Four phases, and what each one rewards

The cycle has four phases and they always run in the same order. Expansion is rising output, rising employment and rising corporate earnings. The peak is the top: the month activity stops rising, which the National Bureau of Economic Research dates as the last month of the expansion. Growth merely slowing is not a peak — an expansion can decelerate for years and keep going. Contraction is falling output with rising unemployment. The financial press often calls two consecutive quarters of falling real gross domestic product a recession; most recessions include such a stretch, but not all. The trough is the bottom, where activity stops falling and starts to turn.

Companies do not all move with the cycle. Cyclical companies sell what a buyer can postpone: a new car, a holiday flight, a kitchen refit. Their earnings swing hard in both directions. Defensive companies sell what people buy in any month — electricity, groceries, basic medicines — so their earnings are steadier. That is why defensive names hold up in a contraction and lag in a strong expansion.

Growth is a separate axis, not a synonym for defensive. A growth company reinvests its earnings and is priced on what it might earn years from now, so it usually pays little or no dividend. Defensive describes the stability of demand; growth describes where the earnings are expected to come from. A water utility can be thoroughly defensive, pay a large dividend, and be no kind of growth company.

Indicators are sorted by when they turn. The Conference Board publishes three composite indexes. Leading indicators have turned before the economy: its leading index includes building permits for new private housing, manufacturers’ new orders, stock prices and weekly initial claims for unemployment insurance. Coincident indicators turn at about the same time as the economy: payroll employment, personal income less transfer payments, manufacturing and trade sales, and industrial production. Lagging indicators generally turn afterwards and confirm the turn: the lagging index includes the average duration of unemployment, the average prime rate and the ratio of inventories to sales.

Two definitions behind the phase names are worth having exactly. The Consumer Price Index, published by the Bureau of Labor Statistics, measures the average change over time in the prices paid by consumers for a representative basket of goods and services; it is inflation as households actually meet it and the most widely used measure of it. And the two-quarters-of-falling-GDP line is a press shorthand rather than the official test: the NBER says most of the recessions it dates include two or more such quarters, but not all of them. The body that dates US recessions, the National Bureau of Economic Research, calls a recession a significant decline in economic activity spread across the economy and lasting more than a few months, judged on three criteria — depth, diffusion and duration — that it treats as somewhat interchangeable, so an unusually severe decline can qualify even if it is short.

Company results arrive in financial statements, and two of them answer different questions. A balance sheet shows what a company owns and owes at a moment in time: its assets, its liabilities and its shareholders’ equity, and it balances because assets equal liabilities plus shareholders’ equity. An income statement shows performance over a period, usually a year or part of a year: the revenue the company earned and the costs and expenses of earning it. One is a snapshot of position; the other is a record of results over time.

Exam terms

Expansion

Output, employment and earnings are rising.

Contraction

Output falls and unemployment rises; a significant decline spread across the economy and lasting more than a few months is a recession.

Trough

The bottom of the cycle, where the fall stops and recovery begins.

Cyclical company

Earnings swing with the cycle because its goods can be postponed.

Defensive company

Earnings are steady because demand for its goods barely changes.

Leading indicator

A measure that turns before the wider economy turns.

Worked example

Two holdings run through one full contraction: shares in a discount airline and shares in a regulated water company.

1. The contraction begins. Households postpone holidays, so seats go unsold and the airline’s revenue falls quickly; it still has to pay for aircraft and crew, so earnings fall further than revenue does.
2. Nobody postpones drinking water. The water company’s volumes barely change, its prices are set by a regulator, and its earnings hold roughly flat.
3. The airline is cyclical, the water company is defensive, and the market prices them accordingly during the fall.
4. The trough arrives and expansion begins. Now the ordering reverses: the airline’s earnings recover sharply from a low base while the water company grows slowly, so defensive holdings lag.
5. Neither company became a growth company at any point. Growth would mean reinvesting earnings for future expansion, which is a different question from how demand behaves in a downturn.

Check yourself

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Related practice

• Business cycle phase and sector behaviorPractice this