Navigating the ups and downs of the business cycle is essential for anyone invested in the economic marketplace, whether you’re launching a startup or steering a thriving enterprise. Aspiring entrepreneurs and current small business owners need to analyze the opportunities and risks of each cycle for their industry. If you’re an investor, knowing which assets (such as stocks) perform well in the different phases of a business cycle can help you avoid risks — and even grow the value of your portfolio.

Let’s review what a business cycle is and then explore the four stages within each cycle.

What’s a Business Cycle?

A business cycle can be understood as the natural ebb and flow of economic activity. (Business cycles are also known as economic cycles or trade cycles.) The chief metric of a business cycle is the gross domestic product (GDP), which measures the market value of all finished goods and services produced in the U.S. in a specific time frame (such as a quarter or year). Economists also measure other indicators of economic activity in a business cycle, such as employment, personal income, sales, consumer confidence, and more.

When the GDP and other measures of economic output are positive, times are good. The production of goods and services is strong and driven by robust customer demand. Businesses are at full employment or hiring, which tends to make consumer income strong and expansible. Consumers and businesses feel flush and tend to purchase their desired goods and services.

When the business cycle is negative, times aren’t so good. Production of goods and services may falter or be low. If production falls, companies may lay off workers. Workers then have less income and may curtail purchases of goods and services, which in turn can lower production. A contractionary phase can start a vicious cycle of more contraction.

There are four main stages in a business cycle: expansion, peak, contraction, and trough.

1. Expansion

In an expansion phase, businesses are growing. Aggregate output is increasing, and they may be hiring more workers to ramp up production. Customer demand is strong, and businesses are confident they can sell the goods and services produced.

In an economic expansion, GDP will be around two to three percent. Inflation will run at approximately two percent as well. Unemployment stands in a range of 3.5 to 4.5 percent. Wages may rise due to the strong demand for workers. Stock prices climb in an expansion, because strong customer demand and production generally raise company profits.

2. Peak

At a peak phase, expansion starts to overheat. Business owners and investors may become overconfident and expand too much for demand, opening new offices or rolling out new product lines. Wages may rise unsustainably high. Inflation may rise above 2 percent.

Inflation is an economic danger because it decreases the value of cash for both businesses and consumers — and causes higher prices. This can cause both businesses and consumers to cut back on spending, which will ultimately dampen production.

At the peak of a business cycle, GDP might appear strong. However, if inflation escalates or unemployment drops too low, pushing wages higher, it can signal looming economic troubles. High inflation can suppress consumer demand, leading to a decrease in the production of goods and services. This shift often indicates that the economy might be heading toward a downturn.

The measurement of a peak is only known once the next period falls from it, so it’s only known in hindsight. As a result, a peak can resemble expansion until a period of time has elapsed. That’s one of the reasons that watching inflation and job figures is so important for investors and entrepreneurs.

3. Contraction

In a contraction phase, production starts to fall. GDP drops from the previous period (month over month or quarter over quarter), and falls below two percent. Companies may lay workers off due to declining production.

Laid-off workers will generally have less to spend, so they will pull back on purchases, which can cause more of a contraction for businesses dependent on consumer demand. Falling production can also lead to declining business profits, which can negatively affect the stock market.

A decline in GDP for two quarters in a row is often used as a marker of economic recessions.

4. Trough

The trough is the lowest point of the contraction — the point at which the rate of growth is the lowest. Like the peak, though, the trough is only clear in retrospect. Suppose the GDP in one quarter comes in at 1.3 percent, and the next quarter is registered at 1.5 percent and continues to rise from there. In that case, the 1.3 percent GDP period will be defined as the trough.

It’s important for small businesses to understand, though, that the escape from a contraction doesn’t necessarily happen all at once. GDP can fluctuate quarter to quarter and go back down after an initial rise from a trough.

At the trough, production and the employment level generally stand at the lowest point in the cycle. Stocks may be in a bear market, because profits are low.

If the GDP continues to rise after a trough, a fledgling expansionary phase has begun and will be official once GDP hits around two percent.

Factors That Influence Business Cycles

Many factors influence business cycles. They are very influenced by supply and aggregate demand. Supply and demand, in turn, are influenced by factors such as supply chain disruptions and consumer and business confidence and behavior.

Governments play a crucial role in influencing business cycles. When the economy begins to overheat and inflation pressures rise, governments typically respond by adjusting monetary policy. Increasing interest rates is a common strategy to cool down an overheated economy. Higher interest rates make borrowing more expensive for businesses, which often leads to reduced production and, consequently, lower inflation. This increase in borrowing costs also affects consumers, as it makes loans and credit more expensive, potentially decreasing consumer demand.

Governments also like to see a relatively healthy economy and employment rate. So, if the economy starts to contract, they may lower interest rates. Declining interest rates makes borrowing cheaper, which can incentivize businesses to ramp up production and expand. They can also incentivize consumers to purchase more, thus driving demand.

Government adjustments to tax policy can also affect business cycles. A decrease in taxes can put more money in the hands of businesses and consumers, which could increase demand.

Business cycles can also be influenced by sudden and unexpected events, such as wars and global crises. The war in Ukraine disrupted oil supplies, for instance, and the COVID pandemic disrupted businesses, particularly in sectors like restaurants and travel.

How Understanding Business Cycles Can Help Entrepreneurs

How can an understanding of business cycles help aspiring and current small business owners? Simple. It provides an understanding of opportunities and challenges that you will encounter. For prospective business owners, it can also provide an indication of when you should start a business.

Simply put, starting or running a business in an expansion is a best-case scenario. Consumer and business confidence is high and thus customers are more likely to purchase your goods and services than they are in contractions or troughs.

At a peak, you should be careful to not overextend yourself. You may encounter challenges in hiring, as there is a great deal of competition for workers.

In periods of economic contractions, you may encounter challenges in sales and profits. You may have to lay workers off.

It’s prudent to create scenarios for all four business cycles when business planning.

It’s also important to understand how your individual business and sector will fare in each scenario. If you are selling essential goods and services, such as groceries or car repair, demand for your product may be relatively constant throughout all the cycles. But if you’re selling goods or services that people can easily do without, such as customized birthday cakes, be aware that customers often cut or delay purchases in downturns.

Contact Guidant Financial for Financing Options

If you’re planning to start or expand a business, Guidant Financial is here to guide you through the complexities of financing. We offer expert advice and mentorship on a range of financing options tailored to meet your unique business needs.

Our specialists can help you navigate the intricacies of U.S. Small Business Administration (SBA) loans, ensuring you understand the requirements and processes involved. We also provide comprehensive support for Rollovers for Business Startups (ROBS), an innovative way to finance your venture using your retirement funds without incurring early withdrawal penalties.

Learn more about your financing options by booking a FREE business consultation with one of our experts — call 425-389-3200.

Call us today at 425-289-3200 for a free, no-pressure business consultation to get started — or pre-qualify in minutes for business financing now!

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