Understanding a Business cycle

Understanding the business cycle is a must-have skill for an investor. These cycles differ from one economy to another and from one sector to another within an economy. Understanding various stages of business cycles is important for investors to make sound investment decisions.
Understanding a Business cycle

A business cycle is defined as the natural rise and fall of economic growth. In simple terms, when an economy faces a shortage in demand, it is considered to be in a down cycle. And, when demand is surging, the economy is considered to be in an up cycle.

This cycle varies from company to company, sector to sector, and even from one economy to another. Identifying a business cycle is useful to analyze the prospects of a business or economy and helps you to make informed choices.

So, how to identify a business cycle? Let’s understand this with a simple example.

A restaurant runs its business near a college. Students are its primary customers. So, when the college is closed for a long period of time, the business will see a slump in demand. It will pick up again when the college reopens. Here, demand fluctuates around the availability of the students. That is a crucial factor determining the business cycle of that restaurant.

Depending on the nature of business, factors like change in seasonal, demographical, tastes and preferences, or government policies could affect their business cycle.

For industries like cement and construction, seasonal factors will determine the business cycle. During the monsoon, the activity level will reduce sharply, resulting in lower demand. Same for vehicle manufacturers, they see lower offtake for their products during monsoon. On the flip side, consumption improves around festive seasons around Diwali and Christmas.

On similar lines, an economy also goes through a period of high demand followed by contraction. Usually, a business cycle for an economy is of a much longer duration. It could last for months, years or even decades considering the fundamental environment of that country.

Phases of business cycle:

Each business cycle has four phases: expansion, peak, contraction, and trough. They don’t occur at regular intervals, but they do have recognizable indicators.

During the expansion phase, the economy experiences rapid growth. Government policies are pro-business, there is plenty of money flowing around, interest rates are low and unemployment falls. This period is also marked by rising demand. The economy sees increasing production and profitability. The expansion period is usually accompanied by high inflationary pressures.

The peak is the second phase where the growth rate is at its maximum. At peak level, the economy develops imbalances like a demand-supply mismatch. As demand declines, production facilities operate at lower levels. Level of debt also increases in the system during this period. As the economy starts correcting this mismatch, the growth starts to slow down.

Once an economy peaks out, the contraction phase takes over. Demand starts falling, capacity utilization level starts dropping, employment falls and banks start seeing rising stress. During this phase, the economy opts for mean reversion. In this, stock prices correct back to their long-term average.

The trough of the cycle is reached when the economic activities are at a complete bottom. From this level, growth begins to recover and the cycle repeats itself all over again.

How to invest with business cycles:

Business cycles could differ from one sector to another and have varying impacts on companies. Hence, identifying the bottom is nearly impossible. But, it is ideal to start investing in the last phase of contraction or during the early phase of an expansion.

Investors can also keep track of leading indicators like fresh policy measures from government and central bank, peak up in demand for fuels and commodities like steel and other metals as a sign of revival – to judge the turnaround in the business cycle.

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