What is the business cycle and what does it mean for investors?

Share markets don’t follow the business cycle – but they can predict it

Some people assume that the business cycle indicates what will happen on the share market. But the share market is actually considered to be a leading indicator of the business cycle.

The reason for this is that investors need to look forward while economic indicators are generally backward-looking. Investors look forward to assess the outlook for company revenues and profits - and therefore the future value of share prices. Economic indicators look back at statistical data to provide a report on the economy’s health during a period of time.

When an investor decides how much they’re willing to pay for a share, they base that decision on what they think will happen to that share in the future. If they expect the economy to grow and share prices to go up, they will factor this into the share price they’re willing to pay today. This is why it’s generally thought that a bull market will peak before the economy peaks, and a bear market will end before the economy bottoms out.

An example

Let’s say consumer spending has been robust over the last year. The Australian Bureau of Statistics (ABS) has reported its official numbers on retail turnover for the latest quarter, and it’s up 1.2% from the previous period. This is what’s known as an economic indicator, and in this example, it’s showing positive growth in consumer spending for the period.

However, what if there was a shift in interest rate policy during this period, or changes in lending criteria that will adversely affect consumers? Even though the economic data looks good, investors in consumer shares would be looking forward to how the interest rate or lending policy change might affect their shares. They would react based on their expectations about a future downturn.

In this scenario, investors may sell some of their Consumer staples/discretionary shares. If many investors shared the same view, this could potentially cause a decline in share prices in this sector. So even though economists are saying that consumer spending is growing, the current state of the share market would tell a very different story.

Timing your investments with the business cycle

Getting to know the business cycle is useful because some investors may use it to try to time their entry to or exit from the market. The theory is that you could make a gain by buying shares when prices are depressed, and selling them when prices have recovered. But timing the market is very hard to do in practice. It’s easy to recognise a peak or a trough after it has already happened, but trying to predict one is another matter entirely. For many investors, the better approach over the long term could be a buy-and-hold strategy or making many small purchases over time.

A chance to rebalance your portfolio

Even if you’re not trying to time the market, paying attention to the business cycle can still have benefits. Some investors will review their portfolio whenever they perceive that the business cycle is entering a new phase. For example, during a recession, an investor might adjust their portfolio to allocate more of their savings to bonds instead of shares. On average, bonds tend to be less volatile than shares, so the investor might feel that switching to bonds will lower their exposure to risk. When investors perceive that the economy is about to recover, the investor might switch back to shares, which tend to have a higher potential for growth of total returns when compared to bonds.

Watching the business cycle could also highlight specific investment opportunities. For example, in a domestic recession, it could be reasonable to expect that the Reserve Bank will push interest rates down to encourage businesses and individuals to borrow. As this cycle plays out in the share market, smaller companies (which are more growth-dependent) may be best positioned to take advantage of the early stage of a recovery.

Let’s wrap up:

• The “classic” business cycle measures the upward and downward movements of the economy over time.
• It is generally defined that there are four phases in the business cycle: expansion, peak, contraction, and trough.
• The share market is generally considered a leading indicator of the business cycle. The share market may fall before the business cycle enters a period of contraction, and the share market may start to recover before the business cycle hits a trough.
• As an investor, you can estimate the current point in the business cycle and consider what it means for your investment portfolio.
• Whenever the business cycle enters a new phase, each asset class will be affected in its own way. You might take the opportunity to review your portfolio and see whether it's prudent to rebalance your asset allocation.
• You can find the latest economic updates from CommSec's expert team on The Markets page.

[1] https://www.asx.com.au/education/glossary.htm
[2] https://www.investopedia.com/terms/b/businesscycle.asp