Understanding economic cycles: An introduction

(Since April is Financial Literacy Month, a number of articles will be devoted to more educational topics. This is Part I in a four-part series about how understanding economic cycles could inform your financial decisions. Part II is Recognizing economic seasons: recovery and growth. Part III is The fall and winter seasons of the economic cycle. Part IV is How to profit from economic cycles.)

Getting rich slowly is built on these four commonly understood pillars:

  1. Get out of debt (and stay out of debt)
  2. Find ways to earn more
  3. Spend less than you earn
  4. Invest the difference

Despite the fact that many people followed those four guiding principles during the Great Recession, some “got poor quickly” instead. I believe that is because there is something else to know about the economy and how it affects our finances. This post is the first in a short series explaining what I understand about the economy and its seasons.

I believe that, if you grasp the concepts presented here, it can help you avoid some of the financial hardships recessions bring. More than that, though, it is also possible to benefit from opportunities you may not have recognized in the past. For example, my family's net worth tripled in the Great Recession using the understanding of the four seasons of the economy, despite some setbacks and other opportunities I missed out on. These concepts don't replace any of the four pillars mentioned above; they simply open our eyes to see opportunities we may have missed before.

Measuring the Economy

The economy includes all transactions where money changes hands. When parents give kids an allowance, that event is as much a part of the economy as Apple's selling 70 million iPhones or your buying a half soy, half caf, half Stevia, double shot at your local, overpriced coffee shop. Although it is impossible to measure each and every one of those billions of transactions a day, the government boffins holed up in their windowless rooms at some hidden location do manage to come up with an estimate which they call the Gross Domestic Product, or GDP.

The Federal Reserve Board, or Fed, uses the GDP as their benchmark of the economy. More particularly, they look at the growth of the GDP each quarter.

The Fed's technical definition of a recession is two consecutive quarters of negative GDP growth, but it is hard for us to relate to something as abstract as the GDP. But we can easily understand having a job, so the unemployment rate is a better measure of the economy for most of us. After all, what is a country if not its people? If those people are working, the economy is good; but if they are not working, it is decidedly not good.

Fortunately, most measures of the economy coincide. When unemployment is at its highest, the GDP is at its cyclical low point, so it doesn't really matter which measure you use.

Our Economic Track Record — Growth Over Time

Looking at America's economy over the past hundred years or more, the number one take-away is its growth. When the economy dips (or goes into a recession) it may feel devastating; but if you look at the big picture, you can see why most people view the American economy as one of the best in the world. Over time, it just keeps growing, as shown in the chart below.

U.S. GDP 1981 – present

You can see how, despite two severe and two minor recessions in the past 30-odd years, the U.S. GDP has more than doubled after adjusting for inflation. (That is what the “Real” in the chart's title means.)

Some part of that is due to population growth: After all, the more people we have giving allowances and buying smartphones, the bigger the GDP. When you track GDP per capita, though, you see almost the same thing. (The following chart uses the data from the previous chart simply divided by the population.)

U.S. GDP per capita 1981 – present

In other words, over time, the U.S. economy is growing — and your income and net worth can be expected to grow too. Still, you can clearly see four dips in the GDP which occurred in the four recessions since 1981. Recessions (those areas where the blue — or orange — line dips in the gray bars) occur regularly. They are part of what we call the economic cycle.

Understanding the Economic Cycle

Most of us have heard that the economy goes up and down. Everyone likes the up part — that's when the economy is doing well and nobody pays attention to it. However, what many do not realize is that the economy drops every seven to 10 years, almost like clockwork.

For now, why the economy tanks every seven to 10 years doesn't concern us — our focus is to arrive at a strategy that will keep us getting rich slowly even when the economy does slip into recession. If we simply think of ups and downs, the economy would have looked something like this since World War II:

The only things to note in this chart are the dates which represent the official dates when each recession bottomed out. The rest of the chart is a simple schematic, exaggerated for effect.

The first purpose of the chart is to help you visualize the up-and-down movement of the U.S. economy. The second is to give you an idea of how short these cycles have been. Historically, 10 years is the longest that it has taken from one bottom to the next — but frequently that interval was much shorter. Seven to 10 years is the range I use when I look at the economy, trying to build an expectation of what lies ahead.

Seven to 10 years may be a good starting point in gauging the duration of a single cycle, but it is not quite as helpful as another number I track: time to downturn. That is how long it takes from a recession bottom to the point where the economy starts turning down. That's a little fuzzier to figure out. And I'm not going to try to represent that this is the ultimate in accuracy; but the way I look at the economy, it takes between four and eight years from a prior bottom to the next downturn. (Some recessions have a quick drop to the bottom while others labor a little longer to get there.)

In other words, if historic trends hold (as they have for a long time), we can expect a downturn between four and eight years after a prior bottom. (And if you are doing the math on the current cycle, you probably recognize that we are already inside the window for the next downturn.)

Visualizing the Four Seasons of the Economic Cycle

So far, this may be interesting only in a purely academic kind of way because it doesn't tell you what you can do about all of this. To figure out a strategy to protect our finances (or even hopefully to profit financially), it helps to consider another concept: the seasons of the economic cycle.

When you look at a single cycle, bottom to bottom, it is possible to identify four distinct seasons that correspond roughly to the four seasons of a year:

  1. the winter of recession,
  2. the spring of the early recovery,
  3. the summer of growth,
  4. and a harvest season

Winter, spring and summer make intuitive sense. The fall/harvest season, though, is the one which presents the most problems. We'll get to that later in the series; but first, there are a few important things to note.

Duration: Each season lasts exactly three months in nature, but that isn't the case for economic seasons. Each economic season can last years.

In fact, economic seasons are not all the same length. Most of the time, each one will last longer than a calendar year, but it is impossible to predict how much longer.

Imperceptibility: In nature, it is hard to tell exactly when a season changes without a calendar and an army of meteorologists telling us that spring sprung on March 21 at 4:45 p.m. Most years, the 21st of March feels pretty much like the 20th of March. In fact, a week in April may have a lower average temperature than a week in March. The fact that we are unable to perceive a change in the natural seasons doesn't mean the change isn't happening. We know in time the new season will make itself evident.

It's the same with the seasons in the economy: The transition from one season to the next is fuzzy and unclear. However, when you look back, you can usually see things have changed.

Sequence: To me, the most important thing about the four seasons is that the sequence never changes. Spring always follows winter, and fall always follows summer. Therefore, once we are able to identify which season we are in, we have a good idea of what is coming next. That may sound simple and obvious, but you would be surprised how many people don't think of it like that. (More of that in the following installments of the series.)

This — the fact that we can predict which season will follow the one we are in — holds the key to our being able to:

  • protect our finances from the hurts that recessions can bring, and …
  • benefit from opportunities many overlook.

In the next part of the series, I will attempt to explain how understanding economic seasons can help you plan your finances in the same way farmers use the seasons of nature to earn a living.

How many recessions have you experienced? What did you learn about how to weather an economic downturn?

More about...Economics, Investing, Planning

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Beth
Beth
5 years ago

Interesting… I’m not sure I agree with trying to time the market, but I find I’m not in a hurry to invest right now when I suspect there’s a downturn headed our way. I suspect others were in the same boat, but went the last recession hit I was worried about losing my job and kept a healthy store of cash in more liquid vehicles rather than buying stocks “on sale”. Many of us were grateful to have a job, let alone extra cash to invest. I wonder what will happen this time? If our government increases the TFSA limit… Read more »

Brad
Brad
5 years ago
Reply to  Beth

Timing the market is extremely difficult. I prefer to focus on dollar cost averaging. This is why the average annual return for a total stock market index fund is considered around 6-7%. Some years (like the past few) the return will be 10+%. However, you’ll get a few years of 1-2% or even negative returns.

I don’t time the market, I just invest for the long haul and expect an average return of 6-7% of every dollar I invest. Thus avoiding the pitfall of trying to squeeze out an extra 1% by timing things and probably making a costly mistake.

William Cowie
William Cowie
5 years ago
Reply to  Beth

This series is NOT about market timing, despite how it may appear. As the series unfolds, I hope that becomes clear.

Understanding economic cycles impacts every aspect of your financial life, from your job and your home to your investments and even your vacations.

Beth
Beth
5 years ago
Reply to  William Cowie

I’m looking forward to more in the series 🙂 Normally, I’m a dollar cost averaging kind of investor but when you end up with a lump sum, what do you do?

Curious to hear more!

Adam
Adam
5 years ago

Interest rates are already as low as they can go. So what does the Fed do if the next downturn strikes relatively soon? More quantitative easing? How far in debt are they willing to go? I think the answer is that taxes go up. Predominantly on the wealthy, but I believe the middle class will bear some of that burden too. The US currently has a $1T deficit annually. This is why I maximize my Roth IRA, and elected for a Roth 401(k). As the debt continues to climb, taxes will inevitably have to rise to keep it at a… Read more »

getagrip
getagrip
5 years ago

I’ve been through a few recessions. Bottom line, not panicing, dollar cost averaging, being somewhat conservative, and letting it ride in index funds has provided me with a nest egg more than double the amount of money I have put into it. Had I been able to time the market, I would have tripled or quintupled where I’m at. Yet every time I tried timing the market (generally with a portion of the portfolio), I’ve gotten it wrong and suffered some for it. For example, everyone knows a dip is coming, but will it be this year? next year? How… Read more »

Bill Morton
Bill Morton
5 years ago

I recall taking an Economics course in business cycles back in the early 70’s. Although I haven’t used it directly in my career, I have certainly recalled it and its lessons as the years have marched on.
I have been amused a number of times as different Presidents have said, “look what my policies did” when in terms of the economic cycles they just happened to be in office at the right time.

Jess
Jess
5 years ago

I’ve technically “experienced” three recessions – but have only been consciously aware of the most recent, which began the fall of my senior year of college. I started my first job about a year after that, and as soon as I turned full-time and was eligible for a 401(k) and the company match, I put in as much as I thought I could stomach while also paying off my student loans at more than the minimum payment. I set my 401(k) withholding to increase each year (and could probably stand to up it again,honestly), and when my loans became more… Read more »

Laura
Laura
5 years ago

LOVE this article and am looking forward very much to the rest in this series. I really like the idea of economic cycles having the same qualities as seasons.

Personally, I think the next recession will hit in 2017, after the next presidential election (rather like when Ronnie Reagan took office). I’m focusing on “making hay while the sun shines.”

Calicker
Calicker
5 years ago

Thanks for this post. As a college kid in ’09, the effects of the recession were not as evident because of the joys of using the excuse “young” “wild” and “free”. Now, the tables are completely turned and now have an opportunity to be better equipped to know when to re-allocate for the next downturn and to increase my risk once we’ve weathered the storm.

What strategies are you guys recommending at GRS for hedging risk as we approach a correction in the stock market, increase in interest rates, and other economic changes?

Cautious
Cautious
5 years ago

I can’t wait for the other articles to follow in this series. This article taught me a lot and was very timely. The last recession I made several mistakes in investing. The main mistake I made was being way too cautious. The next recession I will risk more. This article was not about market timing, but rather learning how to make better informed financial choices based on the economic “season.” Thank you Mr. Cowie.

Jeroen
Jeroen
5 years ago

Nice analogy between the economy and the seasons. It’s pretty obvious to make that comparison, yet I have not seen it done before, nor thought of it this way. But your article is somewhat incomplete. Yes, the 7-year cycle (Juglar-cycle) is the best known cycle. It is even Biblical, as in the prepare for the skinny years in the fat years story. But it is far from the only cycle. Other known cycles: Kitchincycle – 3 to 5 years Kuzentscycle – 15 to 25 years Kondratieff-cycle – 45 to 60 years And all these cycles interact with one another, so… Read more »

nicky at not my mother
nicky at not my mother
5 years ago

This is one of the most useful and interesting articles I have read in this site in the last few years. I’d love to understand the cycles and how things like the GDP link in, not from a timing the market perspective, but to understand what they are talking about and to stop feeling like it is all beyond my control. Looking forward to the next one.

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