If we expect the economy to grow in a straight line forever, we are only fooling ourselves. That is simply not how the world works. And this reality directly affects financial markets. Prices in the market do not move randomly. Sometimes the economy accelerates, sometimes it slows down, and sometimes it pulls back. These ups and downs are called economic cycles.
For an investor, the real question is this: Where are we in the cycle right now? Because the stage we are in largely determines which assets are likely to stand out. So come with me, and let me walk you through this process step by step.
Here's a simple illustration of the economic cycle, showing its four main phases:
- Expansion
- Peak
- Contraction
- Trough
Stick figures represent typical behaviors during each stage.
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| 4 Stages of Economic Cycle |
This visual makes it easy to see how the economy moves through each phase and how these stages influence spending, employment, and market activity.
Expansion Phase
The economic cycle consists of four main stages. Within this process, there are also intermediate phases. These represent special transitions that take place inside the main stages of the economic cycle. One of these main stages is the expansion phase.
During the expansion stage of the economic cycle, the economy begins to recover and gain momentum. Production increases. People spend more. As spending rises, the velocity of money increases as well. Company sales grow, and businesses expand production to meet rising demand. This creates a need to hire more employees. As a result, unemployment begins to decline.
This is the period when everything starts to come back to life and optimism rises. That is why it is often called the spring of the economy. When business conditions are strong and confidence is high, markets tend to favor this phase. Growth is present, and expectations of continued growth are reflected in asset prices.
Recovery
The recovery phase is an intermediate stage of the economic cycle. It begins right after the trough. Economic data may still look weak. There is not yet a sense of full excitement, but the decline in the data has stopped. News flow is usually negative. However, some indicators slowly begin to improve. People start to breathe a little easier. This is the first sign that the economy is stabilizing and that the worst days may be coming to an end.
Here is what makes it interesting, friends: the stock market often starts to rise before the economy has fully recovered. That is because markets price in the future. During the recovery phase, investors gradually return to the market, and confidence begins to rebuild.
Rising Demand and Moderate Inflation
People start spending more. Shop windows get crowded, and restaurants fill up. As spending rises, company revenues increase. Profitability goes up, and stock indices begin to reflect this trend.
As demand grows, prices gradually start to rise as well. This increase is generally a positive sign, because households have money and are willing to spend. Moderate inflation usually indicates that the economy is growing in a healthy way. In fact, it is a natural outcome of a lively economy.
Central banks do not make sudden changes to interest rates during this period. However, if growth accelerates too quickly, signals to slow down the economy begin to appear.
Peak Phase
Friends, during the peak phase of the economic cycle, key indicators rise well above normal levels. Economic growth figures break records, but this situation eventually becomes unsustainable. When the economy expands without slowing down, it reaches its capacity limits. Production is strong, employment is high, and demand is intense. However, production capacity starts to strain, and companies struggle to find enough raw materials to meet rising demand.
In this atmosphere, where everyone seems to be racing to spend, the market begins to overheat in an uncontrolled way. At this point, risks increase. This is exactly when central banks step in. In order to curb excess liquidity and cool down the economy, they bring strict measures such as interest rate hikes onto the agenda.
During the peak phase of the economic cycle, everything moves faster than it should and trades at elevated levels. It becomes difficult to sustain such a high pace for long. The economy needs to pause, catch its breath, and slow down.
So how do we recognize this stage? Let me explain.
High Inflation
The first sign of this stage is high inflation, my friends. Prices of goods keep changing, and you hear about price increases one after another. Even if you do not immediately notice it, your money loses value day by day. The amount in your wallet may stay the same, but what you can buy with it gradually decreases. You try to set money aside, yet you are no longer sure what that savings will be worth in the future.
During periods of high inflation, when demand exceeds supply, price increases accelerate. Demand rises to such a high level that producers struggle to keep up. When supply falls short, prices climb rapidly. As the purchasing power of money erodes, the cost of living begins to pressure everyone. Wage increases fail to keep pace with rising price tags.
This situation creates uncertainty not only for consumers but also for businesses that cannot accurately predict their costs. If inflation starts to spiral out of control, central banks respond by raising interest rates. This tightens financial conditions. The market may still be rising, but pressure continues to build beneath the surface.
Asset Bubbles
The formation of asset bubbles is one of the most dangerous periods, when you need to keep your eyes wide open. During this stage, excessive optimism takes over. Prices can detach from their fundamental values. Everyone expects profits, and risk perception declines.
People's behavior begins to change as well. Everyone looks for a way to make money. Investors buy a stock or a property simply because they believe they can sell it later at a higher price. The belief that prices will keep rising becomes so strong that people invest all their savings, and sometimes even money borrowed from banks, into these assets.
This artificial inflation in the market pushes rational decision-making aside. Yet one reality remains: nothing rises forever. Values that increase at such a rapid pace inevitably face a decline.
While it may seem as if everyone is winning, this is often the most dangerous stage, right before a major downturn. Once buyers begin to step back, the bubble is destined to deflate. When it bursts, everyone rushes to sell, but there are no buyers left. That is when it becomes clear that much of the money circulating in the system was never supported by real value.
Do not act on the assumption that prices will continue rising indefinitely. No one knows when the tide will turn. The Dot-com Bubble and the Global Financial Crisis are classic examples of how peak phases can end. When the bubble bursts, the cycle changes direction.
Contraction and Recession Phase
The contraction and recession phase of the economic cycle is the difficult stage when the wind begins to blow in the opposite direction. The optimism that dominated the peak phase fades away, and spending drops sharply. Companies struggle to sell the goods they have produced, and inventories begin to pile up. As a result, investments slow down or come to a halt.
When the economy enters a period of overall decline, cash flow in the market slows and every step becomes more cautious. This stage represents a painful adjustment period, when the economy attempts to correct the excesses built up during the expansion and peak phases.
Growth slows. Spending declines. Corporate revenues begin to fall. Unemployment rises. The previous momentum suddenly disappears. Conditions start to reverse. The economy is no longer expanding; instead, it begins to contract.
Technically, a recession refers to a period of economic decline. However, for markets, expectations matter more than the current data.
So what else happens during this contraction phase? Let me explain.
Unemployment and Profit Decline
Unfortunately, conditions become even harsher at this stage. Imagine that you own a factory or run a small shop. Previously, you could hardly keep up with orders and were constantly busy. Now, however, the phones stop ringing. Customers who used to call regularly no longer reach out. Incoming orders decline or even come to a complete halt. Since your products are not selling, your inventory begins to pile up.
As sales figures fall, your company's profit margins quickly erode. What would you do in such a situation? You would have to cut expenses. And when it comes to expenses, labor costs are often the first target. In order to keep the company afloat, management moves to reduce costs, and employees are usually the first to feel the impact.
This is exactly when layoffs begin. At first, only a few employees are let go. But if conditions fail to improve, more follow. After a while, the number of people searching for jobs in the streets increases.
Once layoffs start, the overall income level in society declines. As individuals with lower incomes reduce their spending even further, companies generate fewer sales, creating a vicious cycle that is difficult to break. In other words, unemployed individuals cannot spend, and without spending, other businesses cannot generate revenue. This creates a chain reaction.
The money flowing into companies decreases, profits shrink, and many businesses even begin to operate at a loss. In such an environment, who would consider starting a new business? Naturally, almost no one. While everyone tries to protect their current position, they also carry growing concerns about the future.
The contraction and recession phase of the economic cycle leads to undesirable outcomes. Rising unemployment and declining profits are among its most painful consequences. Companies cut costs. Investments are postponed. Consumer confidence weakens. In this environment, risk assets remain under pressure.
Deflation Risk
As the contraction and recession phase of the economic cycle progresses, another danger begins to emerge in the market: deflation. In simple terms, deflation means a general decline in prices.
Prices on supermarket shelves start to fall. Clothes in stores become cheaper. Even house and car prices begin to decline. At first, this sounds like good news, doesn't it? You might think, "Great, everything is getting cheaper. We can shop more comfortably now." But deflation is not as innocent as it appears.
Let's imagine a simple scenario. You are planning to buy a phone next month. Today you check the price. A week later, you look again and it is lower. You expect it to become even cheaper next month. What would you do? You would wait. You would say, "Let it drop a little more, then I'll buy it."
Now imagine millions of people thinking the same way. No one wants to buy anything. People postpone their needs and delay purchases because they expect prices to fall further. This is exactly the kind of psychology deflation creates.
So what happens when no one spends? Factories cannot sell what they produce. Stores cannot move their inventory. Businesses that cannot make sales reduce production. When production declines, the need for workers decreases and new layoffs begin. Unemployment rises even further. Those who lose their jobs see their purchasing power weaken. The economy then enters a downward spiral that becomes harder and harder to stop.
That is why falling prices are not always a good thing. For markets to remain active and healthy, prices need to stay at reasonable and balanced levels.
If demand falls sharply, prices may continue to decline. In such an environment, holding onto cash becomes more attractive than spending it. Money starts to feel more valuable than goods. However, this increases the burden on borrowers and weakens overall business activity. In the end, deflation can turn into a force that slows the economy even more and makes recovery much more difficult.
Stagnation
Friends, during the contraction and recession phase of the economic cycle, the economy can sometimes enter a period of stagnation. At this stage, it can neither move forward nor fall back sharply. Everything feels as if it has come to a standstill.
Imagine a city. The streets are quiet. There is no one in front of the shops. You look at the store windows. The products are there, but no one is buying. People stay at home and avoid spending. Factories are operating, but not at full capacity because there are no new orders coming in. You do not see new job postings, and those who are looking for work have not had success for a long time.
Banks are hesitant to issue loans. At the same time, borrowers are unwilling to take risks. Everyone is trying to protect what they already have and is afraid to take new steps. Would you make a major purchase in such an environment? Would you buy a new house or replace your car? Probably not. Because you cannot see clearly what lies ahead. Uncertainty dominates.
This waiting period can last for weeks or even months. This frozen state is one of the most painful phases, when the economy struggles to regain momentum. But remember, every pause eventually leads to movement. Even if we do not know how long it will last, stagnation also has an end.
Stagnation affects financial markets as well. Sometimes the economy fails to show strong recovery for an extended period. There is neither clear growth nor a sharp collapse. For investors, this becomes a true test of patience. Prolonged inactivity reduces risk appetite. Trading volumes decline, and because there is no clear expectation about the future, capital often chooses to stay on the sidelines and wait.
Trough Phase
Friends, the trough phase of the economic cycle is one of the four stages of the economic cycle and also its darkest point. At this stage, the economy has reached its lowest level. News is mostly negative, confidence is weak, and most people stay away from the market. Unemployment is high, businesses struggle, and economic activity has dropped to a minimum. Streets are quiet, shop windows display "for rent" signs, and factories operate at low capacity or remain closed. People limit their spending and focus only on essential needs.
The trough of the economic cycle is the time when hope is at its lowest. Headlines talk about layoffs, bankruptcies, and business closures. Many people wonder, "How much worse can it get?" Yet this is exactly where an important truth appears: the trough is also the point where the decline ends. Prices have fallen significantly, selling pressure has largely disappeared, and there is little room for further decline. This slowdown in falling prices signals that the market is preparing to recover.
At this stage, while most are pessimistic, some investors quietly begin to take positions. Valuations may have dropped below reasonable levels. Central banks' earlier actions start to take effect, interest rates are low, and liquidity increases. Unemployment may still be high, but its rate of increase slows. Economic deterioration stops and a sense of balance begins to return. This stabilization forms the foundation for a new recovery phase.
Remember, the economic cycle never stays in one stage forever. The trough phase is not permanent. Needs may be delayed, but they cannot be postponed indefinitely. Eventually, demand slowly returns, production picks up, and employment starts to recover. The darkest moment often comes just before the first signs of light. This phase quietly sets the stage for the next growth period in the economic cycle.
Economic Cycle Phases FAQ
We have put together some short questions and answers about the different phases of the economic cycle that might catch your interest. This FAQ will cover key points about the main stages and transitional phases. Hopefully, it can be useful for your own decisions. Take a few minutes to scroll through and see how each stage can affect everyday life and investments.