Market Behaviour : The Basics of the Business Cycle
The old adage “What goes up must come down” is as true for the economy as it is for any physical object. When a business cycle reaches its peak, nothing is wrong in the economic world; businesses and investors are making plenty of money and everyone is happy.
Unfortunately, the economy can’t exist atits peak forever. In the same way that gravity eventually makes a rising objectfall, a revved-up economy eventually reaches its high and begins to tumble.
The peak is only one of the four distinct parts of every business cycle —
peak, recession, trough, and expansion/recovery (see Figure 5-1). Although
none of these parts is designated as the beginning of a business cycle.
hereare the portions of the business cycle that each represents:
✓ Peak: During a peak, the economy is humming along at full speed, with
the gross domestic product (GDP — more about that later in the chapter)
near its maximum output and employment levels near their all-time
highs. Income and prices are increasing, and the risk of inflation is great,
if it hasn’t already set in. Businesses and investors are prospering and
very happy.
✓ Recession/contraction: As the old adage goes, “All good things must
come to an end.” As the economy falls from its peak, employment levels
begin to decline, production and output eventually decline, and wages
and prices level off, but more than likely won’t actually fall unless the
recession is a long one.
✓ Trough: When a recession bottoms out, the economy levels out into
a period called the trough. If this period is prolonged it can become a
depression, which is a severe and prolonged recession. The most recent
depression in North America was in the late 1920s and early 1930s.
Output and employment stagnate, waiting for the next expansion.
✓ Expansion/recovery: After the economy starts growing again, employment
and output pick up. This period of expansion and recovery pulls
the economy off the floor of the trough and points it back toward its
next peak. During this period, employment, production, and output all
see increases, and the economic situation again looks promising.
How do we know which part of the business cycle the economy is in?
Officially, we don’t usually find out until months after that part of the cycle
has either started or ended.
The underlying process of the business cycle is of interest to analysts and
traders. Statistics Canada’s foray into this area has been well received by
analysts over the years. Although no other organization has undertaken the
work, it’s worth noting that Statistics Canada is not providing “official” reference
cycle dates in the sense that the results are beyond dispute or that
StatsCan has a legislated requirement to do so.
In identifying the economy’s ups and downs by determining the cyclical turning
points, StatsCan allows a better understanding for policymakers and traders
alike.
In America, the National Bureau of Economic Research (NBER) officially
declares the peaks and troughs. The NBER is responsible for formally
announcing the ends of peaks and troughs and signalling when a recession
(end of a peak) or expansion (end of a trough) starts. You can see a table
explaining the peaks and troughs since 1857 at www.nber.org/cycles/
cyclesmain.html. The NBER identified December 2007 as the peak of the
most recent economic expansion, but did not make that pronouncement until
December 2008. By the time the peak was declared, the market had been in a
downtrend for 15 months, including the sharp selloff in September 2008.
As you can see, the time lag between events and when the NBER makes its
announcements can be lengthy. But it can get worse. For example, the NBER
declared on November 26, 2001, that the peak of the current business cycle
was reached March 21, 2001. That was eight months later. But then, in January
2004 the NBER revised its position by announcing that the peak may have
actually occurred as early as November 2000. The end of the trough for this
cycle, November 2001, wasn’t announced until July 17, 2003. In other words,
the economy was in a period of expansion/recovery for 20 months before the
NBER made it official.
Unfortunately for all concerned, information that the NBER needs to make its
official announcements isn’t always immediately available. The process of collecting
economic data and revised preliminary estimates of economic activity
takes time. Estimates and data don’t become available immediately after a particular
part of any business cycle ends. As a result, before drawing any conclusions
the NBER must wait until it sees a clear picture of what’s happening with
the economy.
Although many economists identify recessions and expansions
based on at least two quarters (six months) of economic data, NBER uses its
own models. Still, a growth spurt that lasts one full quarter won’t indicate the
start of an expansion; nor will a decline that lasts a quarter indicate the start of
a recession. Bearing that in mind, a time lag of at least six months is typically
required before the NBER even considers declaring a recession or a recovery,
which effectively renders the official announcement useless for traders.
The peak of a business cycle occurs during the last month before some key
economic indicators begin to fall. These indicators include employment,
output, and new housing starts. We talk more about economic indicators and which of them are critical for traders to watch in the “Understanding Economic Indicators” section later in the chapter. However, because neither
a recession nor a recovery can be declared until enough data are accumulated,
finding a way around the time lag in official information is impossible.
Signals that the economy was weakening became clear to the markets as
early as October 2007, when the major indexes hit their peaks. Looking at
an earlier business cycle, you can see the whole process. Just as in October
2007, clear signs the economy was headed toward a recession were seen as
early as the spring of 2000, which is when the Nasdaq index hit its peak and
began its downward spiral. The effects of the recession took a bit longer to
hit the other major exchanges, but they started a downward trend by the
summer of 2000. Just like in 2008, job losses had started mounting by mid-
2000, and many economists already were sending alarms that the economy
was headed into a recession.
Even though the NBER announced the official beginning of that recession as
March 21, 2001, and the official end of the trough and beginning of the recovery
as November 2001, no significant recovery was seen in the markets until
October 2002. Job growth remained anemic as of early 2004. The first sign
of job growth was seen during the fourth quarter of 2003, after nearly three
years of job losses. That economic expansion finally picked up steam, and
ultimately lasted through 2007 .
Unfortunately, the economy can’t exist atits peak forever. In the same way that gravity eventually makes a rising objectfall, a revved-up economy eventually reaches its high and begins to tumble.
The peak is only one of the four distinct parts of every business cycle —
peak, recession, trough, and expansion/recovery (see Figure 5-1). Although
none of these parts is designated as the beginning of a business cycle.
hereare the portions of the business cycle that each represents:
✓ Peak: During a peak, the economy is humming along at full speed, with
the gross domestic product (GDP — more about that later in the chapter)
near its maximum output and employment levels near their all-time
highs. Income and prices are increasing, and the risk of inflation is great,
if it hasn’t already set in. Businesses and investors are prospering and
very happy.
✓ Recession/contraction: As the old adage goes, “All good things must
come to an end.” As the economy falls from its peak, employment levels
begin to decline, production and output eventually decline, and wages
and prices level off, but more than likely won’t actually fall unless the
recession is a long one.
✓ Trough: When a recession bottoms out, the economy levels out into
a period called the trough. If this period is prolonged it can become a
depression, which is a severe and prolonged recession. The most recent
depression in North America was in the late 1920s and early 1930s.
Output and employment stagnate, waiting for the next expansion.
✓ Expansion/recovery: After the economy starts growing again, employment
and output pick up. This period of expansion and recovery pulls
the economy off the floor of the trough and points it back toward its
next peak. During this period, employment, production, and output all
see increases, and the economic situation again looks promising.
How do we know which part of the business cycle the economy is in?
Officially, we don’t usually find out until months after that part of the cycle
has either started or ended.
The underlying process of the business cycle is of interest to analysts and
traders. Statistics Canada’s foray into this area has been well received by
analysts over the years. Although no other organization has undertaken the
work, it’s worth noting that Statistics Canada is not providing “official” reference
cycle dates in the sense that the results are beyond dispute or that
StatsCan has a legislated requirement to do so.
In identifying the economy’s ups and downs by determining the cyclical turning
points, StatsCan allows a better understanding for policymakers and traders
alike.
In America, the National Bureau of Economic Research (NBER) officially
declares the peaks and troughs. The NBER is responsible for formally
announcing the ends of peaks and troughs and signalling when a recession
(end of a peak) or expansion (end of a trough) starts. You can see a table
explaining the peaks and troughs since 1857 at www.nber.org/cycles/
cyclesmain.html. The NBER identified December 2007 as the peak of the
most recent economic expansion, but did not make that pronouncement until
December 2008. By the time the peak was declared, the market had been in a
downtrend for 15 months, including the sharp selloff in September 2008.
As you can see, the time lag between events and when the NBER makes its
announcements can be lengthy. But it can get worse. For example, the NBER
declared on November 26, 2001, that the peak of the current business cycle
was reached March 21, 2001. That was eight months later. But then, in January
2004 the NBER revised its position by announcing that the peak may have
actually occurred as early as November 2000. The end of the trough for this
cycle, November 2001, wasn’t announced until July 17, 2003. In other words,
the economy was in a period of expansion/recovery for 20 months before the
NBER made it official.
Unfortunately for all concerned, information that the NBER needs to make its
official announcements isn’t always immediately available. The process of collecting
economic data and revised preliminary estimates of economic activity
takes time. Estimates and data don’t become available immediately after a particular
part of any business cycle ends. As a result, before drawing any conclusions
the NBER must wait until it sees a clear picture of what’s happening with
the economy.
Although many economists identify recessions and expansions
based on at least two quarters (six months) of economic data, NBER uses its
own models. Still, a growth spurt that lasts one full quarter won’t indicate the
start of an expansion; nor will a decline that lasts a quarter indicate the start of
a recession. Bearing that in mind, a time lag of at least six months is typically
required before the NBER even considers declaring a recession or a recovery,
which effectively renders the official announcement useless for traders.
The peak of a business cycle occurs during the last month before some key
economic indicators begin to fall. These indicators include employment,
output, and new housing starts. We talk more about economic indicators and which of them are critical for traders to watch in the “Understanding Economic Indicators” section later in the chapter. However, because neither
a recession nor a recovery can be declared until enough data are accumulated,
finding a way around the time lag in official information is impossible.
Signals that the economy was weakening became clear to the markets as
early as October 2007, when the major indexes hit their peaks. Looking at
an earlier business cycle, you can see the whole process. Just as in October
2007, clear signs the economy was headed toward a recession were seen as
early as the spring of 2000, which is when the Nasdaq index hit its peak and
began its downward spiral. The effects of the recession took a bit longer to
hit the other major exchanges, but they started a downward trend by the
summer of 2000. Just like in 2008, job losses had started mounting by mid-
2000, and many economists already were sending alarms that the economy
was headed into a recession.
Even though the NBER announced the official beginning of that recession as
March 21, 2001, and the official end of the trough and beginning of the recovery
as November 2001, no significant recovery was seen in the markets until
October 2002. Job growth remained anemic as of early 2004. The first sign
of job growth was seen during the fourth quarter of 2003, after nearly three
years of job losses. That economic expansion finally picked up steam, and
ultimately lasted through 2007 .
