The yield curve just inverted. Building permits have fallen three months running. Your client calls asking, "Should I sell everything?" The answer depends on whether you can read the dashboard of economic indicators, and that is exactly what the CFP Board tests.
Four phases: expansion, peak, contraction (recession), and trough. Measured by real GDP, employment, industrial production, and personal income.
During expansion, GDP rises, unemployment falls, earnings grow, and consumer spending increases. Early expansion features easy monetary policy, pent-up demand, and rising confidence. As it matures, capacity utilization increases, labor markets tighten, and inflation builds. The Fed responds by raising the federal funds rate.
The peak marks the high point. Unemployment is at cyclical lows. Inflation is elevated. Leading indicators start turning negative. Credit spreads widen. The yield curve may flatten or invert.
During contraction, GDP declines, unemployment rises, profits fall, and spending contracts. The NBER formally declares recessions. The Fed responds by cutting rates.
The trough is the bottom, activity stabilizes before the next expansion. Troughs are identified only in retrospect. Sentiment is deeply pessimistic.
Common mistakes
- Treating an inverted yield curve as a sell signal. Inversions precede recessions by 12-18 months. Markets often rise for months after the initial inversion. Trap: "Sell all equities immediately" is always wrong. The correct response is tactical adjustment, not liquidation.
- Confusing leading and lagging indicators. Prime rate and unemployment duration are lagging, they confirm trends already established. Building permits, stock prices, and initial claims are leading, they provide advance warning. Trap: "The prime rate is rising, so a recession is approaching", the prime rate is lagging and says nothing about the future.
- Applying sector rotation without client context. Rotating aggressively into cyclicals in early recovery is theoretically sound but inappropriate for a 70-year-old retiree. Sector rotation must operate within the individual investment policy statement.
Bottom line
- Four business cycle phases: expansion, peak, contraction, trough, each with distinct GDP, employment, inflation, and earnings patterns
- Leading indicators turn before the economy: building permits, yield curve spread, initial claims, S&P 500, consumer expectations, new orders
- Coincident indicators confirm the current phase: nonfarm payrolls, industrial production, personal income (ex-transfers)
- Lagging indicators confirm established trends: prime rate, unemployment duration, consumer credit-to-income
Exam shortcut
Stack indicators like a dashboard: if most leading indicators are negative but coincident indicators remain positive, the economy is near a peak. If lagging indicators are deteriorating but leading indicators are turning positive, you are near a trough. "BOSSY C", leading indicators: Building permits, Orders (new), Stock prices (S&P 500), Spread (yield curve), You (consumer expectations), Claims (initial).
The full lesson (about 2,453 words, 16 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- D.29
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