Tracking the Economic Cycle from Expansion to Recession
Part of the Economic Indicators For Dummies Cheat Sheet
The economy cycles through periods of growth and contraction. Knowing the following signs of each economic phase makes planning your investment or business strategies easier:
Expansion: During expansion, consumer spending is growing, especially for purchases of big-ticket products. Although interest rates are relatively low at the beginning of an expansion, they generally rise as the economy grows. Stocks that perform well during expansion include technology companies, durable goods manufacturers like auto companies, and so-called cyclical industries like steel manufacturers and construction companies.
Peak: At this point, most businesses are thriving. However, interest rates are climbing because investors and the Federal Reserve are concerned about the risk of rising inflation. Rising interest rates make new homes less affordable for some consumers. As a result, the number of layoffs rises in the housing sector and other interest-sensitive sections of the economy. The stock market typically anticipates economic peaks, so it's usually in decline by the time the peak arrives.
Recession: Early in recession, sales of consumer products like cars and kitchen appliances begin to fall, leading manufacturers to cut production and staffing levels. Unemployment rises, and personal income falls. Interest rates are generally highest at the beginning of a recession and fall throughout the recession. Most stocks perform poorly during a recession, but stocks of consumer staple companies (like those that produce food, beverages, and household and personal care products), pharmaceutical firms, financial companies, and dividend-paying utilities often hold their value because these firms sell goods and services that people need even when times are tough.
Trough: During an economic trough, businesses have lowered prices for big-ticket products enough to start attracting bargain hunters. The economy begins to find its footing as consumer spending starts to pick up. Sales of new homes often start to rise as buyers lock in attractive prices and low-interest-rate mortgages. The stock market tries to anticipate the coming economic expansion as transportation and cyclical stocks begin to rise.
The key to understanding the current economic situation is identifying when an economic expansion is over (when the peak has occurred) or when a new one is about to begin (when the trough has occurred). Though the periods of peak and trough are relatively brief and difficult to pinpoint, understanding economic indicators can help you identify them.