In the stock market, cyclical stocks represent companies whose performance is heavily influenced by the overall economic climate. These companies' share prices tend to rise and fall in accordance with the business cycle, which goes through periods of expansion, peak, recession, and recovery. When considering cyclical stocks as potential investments, it's important to understand how economic conditions can impact their profitability.
How Cyclical Stocks Work
Economic Expansion: During economic booms, consumer spending rises. Companies that sell discretionary items, such as automobiles, furniture, or restaurant meals, experience increased sales and profits. This leads to a rise in their stock prices, making cyclical stocks attractive investments.
Peak and Recession: As the economy reaches its peak and then enters a recession, consumer spending typically falls. People cut back on non-essential purchases, impacting the sales and profits of cyclical companies. This often leads to a decline in their stock prices.
Recovery: As the economy recovers from a recession, consumer spending gradually increases again. Cyclical companies start to see a rebound in sales and profits, potentially causing their stock prices to rise.
How to Identify Cyclical Stocks
One way to identify a cyclical stock is by looking at its beta value. A beta value or coefficient is a measure of a stock's sensitivity to changes in the market. It is used to indicate a stock's volatility over time compared to the market benchmark.
A beta of 1 suggests that a stock's volatility matches exactly with the S&P 500, an equity market benchmark. A higher beta indicates greater volatility, and a lower beta indicates less. Cyclical stocks usually have a higher beta coefficient than the S&P 500.
Cyclical vs. Non-cyclical Stocks
Whereas the returns on cyclical stocks are often directly correlated with the economy, non-cyclical stocks are those whose performances are not as dependent on the state of the economy.
Non-cyclical companies produce goods or services that are essential like food, healthcare or utilities. These companies are referred to as consumer staples because their products are generally needed regardless of the state of the economy.
Non-cyclical stocks are also called defensive stocks because they are generally lower volatility and often resilient against economic downturns — they typically remain profitable despite economic downturns. This quality can make them an attractive market segment to invest in during recessions.
Examples
Cyclical stocks can be grouped into several categories such as durable vs. non-durable, service and consumer vs. non-consumer. Let's have a look at the various categories and their examples.
1. Durable and Non-Durable
Durable cyclical stocks are companies that offer physical goods that last for more than three years. These products include tangible items such as machinery or automobiles. Non-durable stocks are companies that produce goods that last for less than three years. These represent items that people consume quickly such as cleaning supplies, clothing or food.
2. Service
Service cyclical stocks are companies that provide services to individuals or corporations. These companies are usually found in the leisure, entertainment or travel sectors.
3. Consumer and Non-Consumer
Consumer cyclical stocks are companies that cater to individuals or households — housing, entertainment and retail. Non-consumer cyclical stocks are companies that cater to institutions, such as governments and private companies. An example of a non-consumer cyclical company would be a defense contractor.
Pros
Several aspects of cyclical stocks can make them appear desirable during recessions.
The Potential to Outperform the Broader Market
Cyclicals generally benefit when economies are experiencing growth and expansion. At times, cyclical stocks can also outperform growth stocks and the market as a whole in periods of growth.
Undervalued
More volatile and tracking macroeconomic trends, you may have an opportunity to buy them at lower value during economic downturns.
Diversification
Adding cyclical stocks to your portfolio offers diversification and may help reduce overall risk. Certain cyclical stocks can rise quickly in a healthy economy and potentially offer substantial growth. But it’s not always possible to predict the turn of a cycle, so having cyclicals in your portfolio can help offset the risk of being too conservative, depending on your individual situation.
Cons
Not every quality of cyclical stocks is beneficial.
Dependent on the Economy
Even though economies follow a pattern of rise and fall, timing the cycles can be difficult. As such, it is difficult to know when to trim your position in a cyclical stock and when to hold on to it. Given this, an investor in cyclical stocks may experience losses.
Higher Volatility
Cyclical stocks tend to have a high beta coefficient, which makes them more volatile than the market benchmark. This could lead to large price swings which may cause huge drawdowns on your overall portfolio.
Market Timing
Cyclical stocks are not a set-it-and-forget-it type of investment. Investing in them means you may have to be constantly tracking the market and economic news as this can affect the prices of many cyclical stocks and how you manage them. You typically can’t be a passive investor with cyclical stocks.
Investing in the Flow
Cyclical stocks are found in sectors that produce goods and services that are non-essential. Because of the discretionary spending on such products, their performance is heavily tied to the state of the economy. When the economy is doing well, cyclical stocks tend to do well. In the same vein, when the economy is going through a rough patch, cyclical stocks usually do not perform well.
Investors find that cyclical stocks can be a source of diversification to portfolios because these stocks provide exposure to the economy, balancing against stable or defensive stocks. Just remember that you generally can't afford to be a passive investor with these potentially volatile securities. You have to constantly track economic trends, market forecasts and news.
Frequently Asked Questions
What are examples of cyclical industries?
Examples of cyclical industries include manufacturing, retail and airlines.
When to consider cyclical stocks?
Investors may want to consider cyclical stocks if they want to add beta to their portfolio — i.e. additional risk that’s tied to the economic cycle. However, that cannot be the only reason to consider cyclical stocks. It’s important to do your research on different factors as well.
How do you tell if a stock is cyclical or non-cyclical?
You can tell if a stock is cyclical or non-cyclical by its sensitivity to economic cycles. Cyclical stocks are more affected by economic downturns or expansions, whereas non-cyclical stocks are typically more stable.