According to the Federal Reserve Bank of Richmond, these phases are inevitable. The more you understand their phases, causes, and history, the more you can protect yourself from their effects.
Phases of the Boom and Bust Cycle
The boom and bust cycle has the same four phases as the business cycle. The boom phase doesn’t typically end unless the economy overheats. There’s too much liquidity in the money supply, leading to inflation. As prices rise, irrational exuberance takes hold of investors. The growth rate grows above 4% for two or more quarters in a row. You know that you’re at the end of a boom phase when the media says the expansion will never end. That’s when even the grocery clerk is making money from the latest asset bubble.
Peak
The end of the boom or expansion phase is the peak. According to the National Bureau of Economic Research, it’s the inflection point where the economy stops expanding.
Bust
The bust phase is the contraction stage of the business cycle. It is brutish, nasty, and mercifully short. On average, it lasts 11 months. The economy contracts, the unemployment rate is 7% or higher, and the value of investments falls. If it lasts more than three months, it’s a recession. It can be triggered by a stock market crash, followed by a bear market. A stock market crash can cause a recession. As stock prices fall, everyone loses confidence in the state of the economy. When investors don’t feel confident about the future outlook, they pull out their investments. They cut back on business activities such as purchasing, hiring, and investing.
Trough
The trough is the inflection point where the economy stops contracting and begins to expand.
Causes
Three forces combine to cause the boom and bust cycle. They are the law of supply and demand, the availability of financial capital, and future expectations. These three forces work together to cause each phase of the cycle. In the boom phase, strong consumer demand is the leading force. Families are confident about the future, so they buy more now. They know they’ll get better jobs, and their home values and investments will increase in value. This demand means companies have to boost supply, which they do by hiring new workers. Capital is easily available, so consumers and businesses alike can borrow at low rates. That stimulates more demand, creating a virtuous circle of prosperity. If demand outstrips supply, the economy can overheat. Also, if there’s too much capital chasing too few goods, it causes inflation. When this happens, investors and businesses try to outperform the market. They ignore the risk of bad investments to achieve gain. In the bust phase, the main force is plummeting expectations about the future. Investors and consumers get nervous when the stock market corrects or crashes. Investors sell stocks. They buy safe-haven investments that traditionally don’t lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral and recession. The bust phase stops when supply lowers prices enough to stimulate demand. It occurs when prices are so low that those investors who still have cash start buying again.
Protect Yourself from the Boom and Bust Cycle
The best way to protect against the boom and bust cycle is to rebalance your investment portfolio once or twice per year. It will automatically make sure you buy low and sell high. For example, if commodities do well and stocks do poorly, your portfolio will have too high a percentage of commodities. To rebalance, you’ll sell some commodities and buy some stocks. That will force you to sell the commodities when prices are high and buy the stocks when prices are low. Know the causes of recession so you can hedge your finances before it happens. Follow the top five leading economic indicators. Look out for signs such as high interest rates. That could lead to declining home prices as sellers offset the higher mortgage costs. Another significant sign is a decline in durable goods orders. Asset bubbles can be just as dangerous. There have been seven since 2005. They occurred in housing, oil, gold, U.S. Treasurys, the stock market, the U.S. dollar, and bitcoin. Study them to make sure you don’t get caught up in the next one.
History
The NBER provides the history of boom and bust cycles. It uses economic indicators to determine when each of the four phases occurred. The most important is the quarterly gross domestic product report. It also uses monthly reports, including employment, real personal income, industrial production, and retail sales. As shown in the chart below, there have been 29 booms or busts since 1929. The NBER has data on boom and bust cycles since 1857.
