In 30 seconds
- The cycle has four phases: expansion, peak, contraction and trough; in the United States the NBER dates them, months after the fact.
- Since 1945, US expansions have lasted 64.2 months on average and contractions 10.3 months.
- Cyclicals suffer far more: Caterpillar's operating income fell 87% from 2008 to 2009; Coca-Cola's fell 2.5%.
- With a cyclical, the lowest P/E tends to come with earnings at their peak: Caterpillar traded at 7.9x at the end of 2008, just before its EPS fell 75%.
- Nobody predicts the cycle reliably; what helps is knowing where you stand and not paying for a record year's earnings as if they were permanent.
Introduction
On December 31, 2008, Caterpillar stock closed at $44.67. The company had earned $5.66 per share that year, so it traded at a P/E of 7.9: cheap, by any textbook. In 2009 its earnings per share fell to $1.43. Anyone who bought at the end of 2008 at $44.67, thinking they were paying 7.9 times earnings, actually paid 31 times the following year's earnings. They weren't wrong about the company. They were wrong about the cycle.
This lesson explains what the business cycle is, how it's measured, how it runs through a real company's financials and what value investors do with it: they don't predict it, but they don't ignore it either.
Explanation
The business cycle is the swing of a country's economic activity around its long-term trend: years when output, jobs and sales grow, and months when they shrink. It isn't a clock with a fixed period. It's more like the seasons in a moody climate: you know winter follows summer, but not on which day or how cold it will get.
The four phases
Expansion: jobs, output and profits grow; credit flows and confidence rises.
Peak: the economy runs at full capacity, unemployment bottoms out, prices start to heat up and central banks tend to raise interest rates.
Contraction, or recession: output, employment and spending fall; companies cut investment and inventories.
Trough: the low point, where the recovery starts.
In the United States, peaks and troughs are dated by the Business Cycle Dating Committee of the NBER (National Bureau of Economic Research), a private nonprofit, and it does so months after the fact. The last three recessions it dated ran from March to November 2001 (8 months), from December 2007 to June 2009 (18 months, the Great Recession) and from February to April 2020 (2 months). According to its table, since 1945 expansions have lasted 64.2 months on average and contractions 10.3 months. Expansions are the rule; recessions are the exception, but a violent one.
Unemployment shows it clearly. According to the Bureau of Labor Statistics (BLS), the unemployment rate went from 4.4% in May 2007 to 10.0% in October 2009, and from 3.5% in February 2020 to 14.8% in April 2020.
The indicators the market watches
The yield curve compares what the US Treasury pays on 10-year debt with what it pays on 3-month bills. Normally the longer maturity pays more. When the curve inverts, the market is expecting rate cuts, and that has often come before a recession. Using the Treasury's daily data, the curve inverted from July 2000 to January 2001 and from July 2006 to May 2007, ahead of the next two recessions. But it was also inverted from October 25, 2022, to December 12, 2024, the longest stretch in recent memory, and as of this lesson the NBER hasn't dated any recession after the 2020 one. A good thermometer, a poor oracle.
Purchasing managers' indexes (PMIs) come from monthly surveys that ask purchasing managers whether they're ordering more or less than the month before: readings above 50 signal expansion, and readings below it, contraction. And unemployment is usually the last to move: it rises once the recession has already started and falls once the recovery is already under way.
Cyclicals and defensives
A cyclical company sells things whose purchase can be put off: machinery, cars, homes, steel, travel. In a recession its customers stop buying, and its profits sink far more than its sales because its fixed costs (plants, workforce, depreciation) don't fall at the same pace. A defensive company sells what people buy crisis or no crisis: food, beverages, medicine, electricity. Its profits barely move. The role of debt and credit in all this is covered in the lesson on how the economic machine works; here we bring it down to one company's books.
Formula
Current P/E = Price / EPS for the latest fiscal year
P/E on normalized earnings = Price / Average EPS over the cycle (5 to 10 fiscal years)
Earnings drop in a recession = (Trough EPS − Peak EPS) / Peak EPS
Operating margin = Operating income / Revenue
Example
The table below shows the trailing twelve-month operating margin of four cyclical companies, using Kaplio's data: Caterpillar (machinery), Deere (farm equipment), Union Pacific (railroads) and Ford (autos). It mixes sectors on purpose: what they share is that their earnings depend on economic activity. And it's a snapshot of a single moment in the cycle. A high margin today may be a good year's margin, not the company's normal one.
Caterpillar across two cycles (10-K for each year, in millions of dollars)
| Fiscal year | Revenue | Operating income | Operating margin | Diluted EPS |
|---|---|---|---|---|
| 2008 | 51,324 | 4,448 | 8.7% | $5.66 |
| 2009 | 32,396 | 577 | 1.8% | $1.43 |
| 2019 | 53,800 | 8,290 | 15.4% | $10.74 |
| 2020 | 41,748 | 4,553 | 10.9% | $5.46 |
| 2023 | 67,060 | 12,966 | 19.3% | $20.12 |
Notice the asymmetry. From 2008 to 2009, Caterpillar's revenue fell 37% and its operating income fell 87%. The plants, the workforce and the depreciation were all still there even when customers stopped buying. Coca-Cola, over the same years, went from $8,446 million of operating income in 2008 to $8,231 million in 2009: 2.5% less. That's what a defensive looks like.
In 2020 the story repeated on a smaller scale: Caterpillar's revenue fell 22% from 2019 and its earnings per share were cut in half. And in 2023, on revenue of $67,060 million, it earned $20.12 per share, 3.7 times as much as in 2020. That isn't growth: it's recovery plus a good stretch of the cycle. If you measure growth from the bad year, you get a number that won't repeat.
Your turn. Calculate Caterpillar's P/E on December 31, 2020 (closing price of $182.02 and 2020 EPS of $5.46) and on December 29, 2023 (closing price of $295.67 and 2023 EPS of $20.12).
Before you look at the answer: on which of the two dates did the stock look more expensive? Answer: 33.3x in 2020 and 14.7x in 2023. It looked very expensive with earnings at the trough and cheap with earnings at a record, exactly the opposite of what intuition says. Nobody could know at the end of 2020 that earnings were about to nearly quadruple. What you could know is that $5.46 was a long way from the company's normal earnings.
Real-data example
| Company | Ticker | Operating margin |
|---|---|---|
| Caterpillar Inc. | CAT | 17.5% |
| Deere & Company | DE | 19.0% |
| Union Pacific Corporation | UNP | 39.9% |
| Ford Motor Company | F | 2.0% |
How to read it
How to read it
With a cyclical, one year's number tells you little; what counts is the average across the cycle. The sector guide on Kaplio's stock pages applies it like this:
| Type of company | Examples | What to look at | Kaplio's guide |
|---|---|---|---|
| Consumer cyclical | autos, luxury, travel, retail | average operating margin over the cycle | healthy from an 8% average over 5 fiscal years |
| Industrials | machinery, railroads, aerospace | operating margin and cash conversion | operating margin healthy from 12% |
| Materials and energy | steel, chemicals, oil | debt against the worst year's EBITDA | net debt/EBITDA healthy below 3x for materials and below 2x for energy |
| Defensives | beverages, food, utilities | stability of earnings and dividend | utilities: net debt/EBITDA healthy below 5.5x |
In "The Intelligent Investor," Benjamin Graham was already telling readers to measure the P/E against average earnings over several years, not the latest one. That's the idea behind any normalized P/E: if this year's earnings are far above their average, the current P/E makes the stock look cheaper than it is.
What value investors do with the cycle
They don't predict it. In "Buy American. I Am.," published in The New York Times on October 16, 2008, in the middle of the crash, Warren Buffett explained that he was buying US stocks for his personal account and summed up his rule: "Be fearful when others are greedy, and be greedy when others are fearful." In the same piece he made clear he had no idea whether stocks would be higher or lower a month or a year later, and he warned that the market tends to rise well before sentiment or the economy turns up. Caterpillar's stock is a case in point: it closed 2009 at $56.99, higher than a year earlier, with earnings 75% lower.
Howard Marks, founder of Oaktree, devoted a whole book to this, "Mastering the Market Cycle" (2018). His thesis, in short: we can't know where the cycle is going, but we can try to figure out where we stand in it and adjust our caution to match. When everyone takes record profits as the new normal, it's time for more caution; when nobody wants to hear about a company, it's time to pay closer attention. Peter Lynch applied it to cyclicals in "One Up on Wall Street" (1989): a low P/E on a cyclical can be the sign that earnings are at their peak and the market already knows it. You'll find this developed in the lessons on the P/E ratio and the PEG ratio.
Pitfalls and limitations
1. Trying to time it. The yield curve stayed inverted for more than two years, from October 2022 to December 2024, without a dated recession. Anyone who sold everything on that signal was left on the sidelines.
2. The low P/E at the peak. It's the trap from this lesson's opening: with a cyclical, the lowest P/E tends to show up when earnings hit a record.
3. Mistaking recovery for growth. Earnings that multiply by 3.7 in three years, like Caterpillar's from 2020 to 2023, can't be projected forward.
4. Defensive doesn't mean immune. Coca-Cola's revenue fell from $37,266 million in 2019 to $33,014 million in 2020, down 11.4%, when bars, restaurants and stadiums closed. Every crisis hits from a different angle.
5. Every industry has its own cycle. Oil, semiconductors or housing can slump while the economy grows. Look at the industry's cycle, not just the country's.
Case in point: the Great Recession in two income statements
Go back to the table. In 2009, in the depths of the recession, Caterpillar earned $577 million of operating income, 1.8% of its sales, and Coca-Cola $8,231 million. A year earlier, on December 31, 2008, Caterpillar traded at a P/E of 7.9 and looked like the market's best bargain. At the end of 2009, with the stock at $56.99 and EPS of $1.43, its P/E was 39.9 and it looked very expensive. It was exactly the other way round: the high P/E at the end of 2009 came with earnings on the floor, and EPS bounced back to $4.15 in 2010. The investor who looked at average earnings over the cycle, not just the last year's, saw both things in time.
Self-assessment scorecard: eight questions for a cyclical
1. Is the company cyclical? How much did its operating income fall in 2009 and in 2020?
2. Is its current operating margin above or below its five- to ten-year average?
3. What P/E do you get using average EPS over the cycle, rather than last year's?
4. Could its debt hold up on the EBITDA of its worst recent year?
5. Did it keep its dividend in the last recession or cut it?
6. Are you drawn to it because its P/E is low, or because the price is reasonable on average earnings?
7. What do the yield curve, the PMI and unemployment say today, and are you using them as context or as a forecast?
8. If a recession hit next year, could you hold the stock without selling at a loss?
Score yourself: with six answers backed by figures from the annual reports, you understand the cyclical in front of you. If questions 3 and 6 don't convince you, the low P/E is probably the trap Lynch warned about.
Practice on Kaplio
Frequently asked questions
What are the 4 stages of the business cycle?
Expansion, when jobs and output grow; peak, when the economy runs at full capacity; contraction, or recession, when activity and employment fall; and trough, the low point where the recovery begins. In the United States, the most recent contraction dated by the NBER ran from February to April 2020.
What are the types of business cycles?
The classic classification sorts them by length: the Kitchin cycle, about three or four years, tied to inventories; the Juglar, seven to eleven years, tied to business investment; the Kuznets, around twenty years, tied to construction; and the Kondratiev, fifty years or more. Ray Dalio adds debt cycles to the list.
What are cyclical vs. defensive stocks?
Cyclical stocks belong to companies whose earnings rise and fall with the economy, such as machinery or automakers: Caterpillar's operating income fell 87% from 2008 to 2009. Defensive stocks sell what people buy even in a crisis, such as beverages or electricity: Coca-Cola's fell just 2.5% over the same years.