Business cycle

The business cycle is the regular occurrence of booms and busts. The economy does not grow evenly and continuously. Instead, there are periodic upward and downward movements of general business activity. There are expansions and contractions.Technically speaking, the business cycle is often defined as cyclical ups and downs of Gross Domestic Product (GDP) around its long-term growth trend. There are many theories why the economy develops cyclically, one of them is the Austrian business cycle theory. The gold - business cycle's link is one of the more important fundamental issues that one needs to analyze when taking long-term investment decisions.

Boom

The boom, or expansion, is the phase of the business cycle when the economy moves from a trough to a peak. During booms the economy is growing, as measured by the rise in real GDP. The expansion is accompanied by positive developments in many indicators, such as employment, industrial production, retail sales and personal incomes. There is also excessive optimism and many malinvestments, and price bubbles emerge.This phase is sometimes divided into the periods of recovery and prosperity. In recovery stocks – the leading indicator of economic improvement – begin to grow, while in the prosperity commodities are often the best investment (due to increased demand and inflation concerns).

Bust

The bust, or contraction, is the phase of the business cycle when the economy moves from a peak to a trough. During busts the economy is declining, as measured by the decline in real GDP (a common rule of thumb for recession is two quarters of negative GDP growth). Unemployment rises, while industrial production, retail sales and personal income falls. There is also excessive pessimism, many wrong investments are liquidated, and many price bubbles burst.This phase is sometimes divided into recession and depression (the most severe part of the recession, when the economy reaches its bottom). To simplify, during recessions, cash is king, while in depression bonds perform the best.

Business Cycle and Gold

Where is gold in that picture? The yellow metal does not flourish in prosperity, when there is excessive optimism and confidence in the Fed and the U.S. economy. However, gold thrives when economies are struggling. Gold is a good investment during recessions due to its role as a safe-haven. As one can see in the chart below, gold gained during most of the several last recessions (the timing of recessions is only approximately reflected by the rectangles).

Chart 1: Gold prices (London 10:30 a.m. fixing) during recessions (indicated by the rectangles) from January 1970 to January 2015

The yellow metal has low or negative correlation with other assets – this is why it is a good portfolio diversifier and it often shines when other asset classes suffer. During the 2008 crash, gold finished the year with a 5 percent gain (although it initially lost due to fire-sales). However, investors should be aware that gold prices do not perform in the same way during different busts. Gold usually perform best in contractions accompanied by uncertainty and a weak U.S. dollar, high and accelerating inflation (remember the 1970s?) or low and declining real interest rates.

We encourage you to learn more about gold – not only how to use it as a portfolio diversifier over the business cycle, but also how to successfully apply gold as an investment and how to profitably trade it. Great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.