The Business Cycle and What It Can and Cannot Tell a Trader

The business cycle is the recurring swing in overall economic activity between periods of growth and periods of decline. Output, employment, income and spending tend to rise together for a stretch, peak, fall together, bottom out, and start rising again.

Four phases are usually named.

Phase	What is happening
Expansion	Activity is growing
Peak	Growth tops out
Contraction	Activity is falling
Trough	The decline bottoms out

A contraction that is broad and lasts long enough is what most people mean by a recession. The cycle is irregular. Phases have no set length, and no two cycles look quite alike.

Who puts the dates on it

In the US, the dates of peaks and troughs are set by the Business Cycle Dating Committee of the National Bureau of Economic Research, known as the NBER. The committee looks across a range of measures of activity, such as employment, income and production, and judges when the economy turned.

It does this after the fact. Its announcements often come many months after the turning point, because the committee waits until the data are clear enough, and revised enough, to call a date with confidence.

That lag is deliberate. It is also the central problem for anyone trying to trade the cycle.

Why late labels matter to you

A trader making a decision today has to act on what is known today. If the official label for a turn arrives months after the turn itself, then for much of any contraction nobody can say with authority that it is one, and for a while after the trough nobody can say with authority that it has ended.

Markets do not wait for the label. Prices move on what traders expect, so by the time a recession is formally dated, much of what the dating tells you may already be reflected in prices.

The hindsight problem in sector rotation

A popular idea says certain sectors tend to do well in each phase, so you should rotate among them as the cycle turns. We make no claim here about which sectors do well when.

The practical difficulty sits in the word “when”. A rotation chart is drawn with the phase dates already known. Looking back, each phase has a clean start and end, and it is easy to see which groups moved in each, but a trader in real time has only partial data, revised later, and has to guess which phase the economy is in and how long it will last before any committee has said so.

So test any cycle-based rule against what was knowable at the time. A backtest that uses the final phase dates is using information nobody had.

Leading, coincident and lagging indicators

Economists sort economic data by timing.

• Leading indicators tend to turn before the economy does. New orders for goods, building permits and weekly claims for unemployment benefits are commonly placed here.
• Coincident indicators move with the economy, such as employment and industrial production.
• Lagging indicators turn after the economy has already turned, such as the unemployment rate.

Leading indicators are the ones traders want. They are also noisy. They can signal turns that never come, and the lead time varies from one cycle to the next, so a single reading tells you little and a run of readings pointing the same way tells you somewhat more.

Data releases are revised. The first print of a number can differ from the version published later, which is one more reason the picture in real time is blurrier than the one in the history books.

What the cycle can tell you

It can give context. Knowing that growth is slowing, or that credit is getting harder to find, helps you judge how exposed your positions are to weaker demand, higher defaults or falling earnings expectations.

It can help you separate broad moves from narrow ones. A decline that hits nearly every stock at once is a different situation from one that hits a single name, a distinction taken up in single-stock dips versus index dips.

It can also point to what else moves with the cycle, such as the government’s finances. Revenue tends to fall and some spending to rise in a contraction, and the borrowing that follows reaches the Treasury market, as described in deficits and Treasury supply.

What it cannot tell you

It cannot tell you where the economy is right now with any certainty. It cannot time an entry. And it cannot tell you what prices already reflect, which is the question the theory of efficient markets is built around.

Use the cycle as background. Your entries and exits need rules that work without knowing the phase.