The following guide explains what cyclical stocks are and highlights how they differ from other types of equities by providing concrete examples. You’ll also learn how these stocks coincide with the four stages of the economic cycle, as well as some recommendations and considerations to bear in mind while investing in cyclicals.
What are cyclical stocks?
Cyclical stocks are securities that are heavily affected by the economic cycles and follow the ups and downs of the overall economy. Cyclicals are usually discretionary products like luxury clothing, furniture, cars, or non-essential services like vacations, travel, and eating out in restaurants.
Note
They are heavily influenced by the economic situation and consumer confidence, as people usually need to reduce their spending during a recession. For example, when the economy is in a downturn, spending on discretionary items like luxury clothing, vacations, cars, new technology, or higher-priced items like furniture also declines.
As consumer spending depends on the overall economic situation, prices of cyclical stocks usually increase when the economy is expanding and decrease when the economy is in a downturn.
In contrast, consumer spending on discretionary items is up during an economic boom, so cyclical stocks are also prospering and growing.
Moreover, as cyclical businesses rely heavily on increased consumption to drive profits and revenues, in the worst-case scenario these firms may even go bankrupt.
In a nutshell, when the economy is up, the prices and spending on discretionary products and services also grows. When the economy is down, the prices of cyclical products and services also decrease, affecting the stock prices.
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Cyclical definition
The term cyclical describes things that aren’t behaving in a stable and regular pattern but occur in irregular intervals – a cycle is where the same events happen repeatedly in the same order.
For example, seasons changing each year, or the sun orbiting the planet – both of these things can be described as cyclical. In the same way that four stages of the economic cycle can be defined as cyclical.
Four main stages of the economic cycle
To fully understand how cyclical stocks are affected by the economic shifts, let’s look at the four stages of the economic or business cycle. Cyclical stocks often rise and fall coinciding with the four economic cycles: expansion, peak, contraction, and through, which form a wave-like pattern as seen on the graph below.
Expansion: comes after through; during this phase, the economy grows. The business cycle begins with the expansion phase, where unemployment decreases and overall productivity and spending increase. Consumers are more eager to invest, which is why the stock market has begun to grow as well.
Peak: in this phase, the high growth begins to slow down and eventually stops. At this point, both the stock market, as well as the employment rates and consumer confidence reaches an all-time high, the economy becomes oversaturated and can’t support the growth.
Contraction: in the third phase of the business cycle, the economy contracts, and the decline begins. The gross domestic product (GDP) rate falls, demand starts to decrease, and unemployment rises. In the US, falling GDP over two consecutive quarters is one of the first signs of an economic recession.
Trough: the economy has reached an all-time low, characterized by high unemployment, low consumer confidence, and less investment activity. At this stage, once prices can’t decline anymore, the recovery phase starts.
Stocks are considered cyclical if the prices correlate with these four phases. For example, in the expansion and peak phases, the prices of cyclical stocks also rise, and during contraction and through stages, prices also decline.
Cyclical vs. Non-cyclical stocks
Non-cyclical or defensive stocks are usually consumer staples less affected by economic downturns. These are the items people need and will keep purchasing despite decreasing disposable income – things like cleaning products, groceries, paper, toiletries.
The performance of non-cyclical stocks is less dependent on the economic shifts, they tend to keep their value even if the economy is in recession. Defensive stocks are for example of companies that offer groceries, gas, or water, these are generally non-cyclical.
For example, during the Covid-19 pandemic, retail and consumer goods manufacturers’ stocks remained stable. A household and personal care company Procter & Gamble (NYSE: PG), known for brands like Tide and Gillette, even got a boost in sales during the pandemic thanks to their large share of revenue coming from consumer staples.
Businesses that sell a mixture of products but a large chunk of sales coming from consumer staples tend to do better despite the economic downturns. For example, companies otherwise considered cyclical – Walmart (NYSE: WMT) and Costco Wholesale (NYSE: CTO), benefited from an increase in sales during the pandemic, and their stock prices remained stable and or even benefited.
People keep purchasing items like food and toiletries even when the budgets are tight, as these products are necessities, and start saving on higher-priced luxury items like cars or furniture. Therefore, consumer discretionary stocks tend to be cyclical and consumer staple stocks non-cyclical.
How to evaluate cyclical stocks?
Even though it is hard to predict the performance, some indicators can assess cyclical stocks.
First of all, cyclicals tend to have high beta values, usually higher than 1, so for example, if the beta value is 1.5 and the market falls by 10%, the stock is likely to fall by 15%.
Secondly, they tend to have more volatile earnings per share or EPS, as earnings fluctuate in economic cycles.
Thirdly, the price to earnings (P/E) ratio tends to be lower for cyclical stocks than defensive stocks, and they can seem cheaper in comparison.
Cyclical stocks categories
Cyclical stocks can be categorized as durables, nondurables, and services.
- Durables are any physical goods that last for more than three years after being sold, meaning that consumers can use the items for at least three years or more before switching and buying new products. The durable product category can involve cars, technology: mobile phones, headphones or laptops, or furniture—brands like Ford, Sony, Whirlpool. The fluctuation in durable consumer goods sales is a good indicator of the future economic situation. If sales and orders are up, it is a good sign that the economy is strengthening, and vice versa. If sales are down, it can be an indicator of an economic decline, as these are all high-priced, non-essential items that could also be used longer if necessary.
- Nondurables: are lower priced and fast-moving goods that have a lifespan of fewer than three years. It includes soft goods like clothing, footwear, and consumer goods such as food, fuel, cigarettes, medications, paper, make-up, or personal care products, for example, grocery and retail stores, Walmart or Target, or footwear and clothing manufacturer Adidas or Nike. Technically, Walmart and Target are cyclical stocks; however, as a large part of their sales comes from nondurable items including essential goods like toothpaste, household products, or groceries, so they are more cushioned against volatile markets movement.
- Services: This category includes services directly impacted by the decreases and increases in consumer spending. In a prospering economy, people tend to have more money to spend on convenience services like Uber or Lyft, dining out, and other leisure activities such as travel and vacations.
What are cyclical industries?
Cyclical stocks are generally concentrated in specific industries. Examples of cyclical industries include restaurants and hospitality, travel and airlines, car manufacturers, construction, real estate, furniture, or luxury retail.
Additionally, it doesn’t matter how big or small the company is; the economic contraction can negatively affect even the largest enterprises. Businesses in these industries have to deal with a great deal of volatility. It isn’t uncommon for them to implement layoffs and budget cuts during economic downturns or have a hiring spree and give out large bonuses during the growth phases.
Companies that operate in such industries are more affected when the economy is struggling. The gross domestic product measures overall economic performance, and a growing economy increases consumer demand.
If the overall consumer purchasing power decreases, fewer people will buy the items in the industries that offer non-essential products or services.
Some of the cyclical industries include:
Automotive industry
The automotive industry is cyclical due to several external factors like seasonal changes in demand, third-party production, and interest rates. The demand trend keeps shifting and isn’t stable and depends mainly on consumer purchasing power. Back in 2020, due to a sudden rise in unemployment and a decrease in consumer spending, revenues for the car manufacturing industry suddenly dropped.
Real estate industry
Real estate is primarily affected by consumer spending power and economic conditions. Investors tend to invest in the REIT sector when they see prices going down, and buyers feel encouraged to buy when the economy is doing well. Therefore, the overall health of the economy plays a crucial role.
Travel and airline industry
The travel industry is cyclical as it relies heavily on consumer spending on vacations and travel. In good economic times, people are more likely to take holidays and take flights to go on these trips than in bad economic times, when people are more concerned about spending.
Therefore, airline stocks are likely to see a significant advancement in performance as the economy improves, travel bans end, and people have more disposable income.
Hospitality
Hotels, restaurants, bars, and other leisure activities providers also often struggle during an economic downturn as people have less money to spend on such extra activities. For example, the hospitality industry took a massive hit during the Covid-19 pandemic in 2020 and is unlikely to make a full recovery any time soon. There are, however, some winners in the market whose stocks are worth investing in, for example, hotel chains that accommodate business travelers.
Retail: luxury fashion and clothing, furniture
Lower-priced apparel is less affected during the economic downturn, as people still need basics and new clothing for work, school, etc. However, spending on higher-priced luxury items, such as watches, jewelry, branded apparel, luxury handbags, or furniture, would go down due to a decrease in disposable income. Again, some companies, for example, the ones who also sell consumer staples and generally do well in an economic downturn.
Financial services
Bank stocks are cyclical as interest rates tend to fall during recessions, and as banks make money from lending, lower interest rates result in lower profits. For example, during a recession, when the unemployment rates are high, consumers are more likely to be unable to pay back their loans, resulting in losses for the banks.
However, of course, each bank is different. For example, consumer banking is more dependent on economic cycles than investment banking. For example, Goldman Sachs (NYSE: GS) saw some of the best quarterly results during the first waves of the Covid-19 pandemic.
Effects of the Covid-19 pandemic on cyclical stocks
In 2020, at the onset of the global pandemic, the stock market crashed as a whole. However, some industries were less affected by the sudden wave of unemployment, decreased consumer spending, and lockdowns. Whereas sectors like physical retail and airlines were severely affected, areas like healthcare or online businesses remained relatively unaffected.
Cyclical stocks can be highly volatile, and it is tough to predict what will happen, as the Covid-19 pandemic showed us. It is valid for all stocks, but as cyclicals follow the business cycles, they can be more volatile, making them incredibly unpredictable.
For example, looking at the Starbucks (NASDAQ: SBUX) stock prices over the last five years, we can see a steep and sudden decrease in stock value during the height of the Covid-19 pandemic.
Amazon’s (NASDAQ: AMZN) stock prices, on the other hand, remained relatively stable throughout, as they benefited from online operations and selling consumer staples like hand gel and healthcare products.
On the two graphs below, we can see how the start of the pandemic in 2020 threw the economy off track, and business cycles changed faster than ever, with travel, automotive, and airline industries among the most affected.
Investing in cyclical stocks
One thing is for sure, investing in stocks always involves risk to some degree and can be very volatile, but some types are more unstable and unpredictable than others. Unlike keeping cash in a savings account, stocks can lose and gain value suddenly over a short period, as is the case, especially with cyclical stocks.
Investing in cyclicals is about managing expectations; the prices can rise and fall suddenly as the economic conditions change. For example, cyclical stocks may appear cheap when one cycle ends, and stock prices start to fall. And on the other hand, when the stock market begins to increase, prices can only seem very high. Therefore, understanding the economic cycles and behavioral finance can help manage these expectations.
There is no one-size-fits-all approach when investing in cyclical stocks, as economic shifts are hard to predict, but there are some important things to know before investing.
What to consider before investing in cyclical stocks
- Consider companies individually: Businesses are classified as cyclical depending on their industry, so it doesn’t necessarily mean they always do poorly in an economic downturn. For example, Disney (DIS) did rather well also during the pandemic due to their Disney+ at-home entertainment. As their amusement parks and shops reopened, Disney’s stock prices benefited from an uptick in value;
- You don’t need to steer clear of cyclical stocks completely: Cyclical stocks can create an excellent return on investment but do consider their amount in your portfolio. It is crucial to diversify and not have only cyclical stocks in your portfolio;
- Even though the gains can be more marginal, it does take more time, effort, and risk as investors need to consider individual stocks and market conditions. For example, the strategy of buying and holding low-cost index funds can offer similar returns with less risk involved;
- The most significant advantage of cyclical stocks is that they can offer high growth and above-average returns during economic prosperity – those with high-risk tolerance can benefit. What is more, historically, recessions don’t last as long as economic growth and happen only once a decade;
- It can be easy to panic when tracking the market and the performance of cyclical stocks. Rather than staying on course, investors may sell at the wrong time, resulting in selling too low and losing money;
- It is often better to buy cyclical stocks during the economic recovery or growth period and sell when things begin to change for the worse. It is not as good to purchase cyclicals during the recession – cyclical stocks can plunge suddenly when the economy is struggling, and selling at the wrong time can result in high losses;
- Some investors may choose to buy cyclical stocks during the economic downturn once prices reach their low point. However, it is riskier as it is hard to predict whether the stocks are at their worst or whether the values will keep dropping.
Conclusion
In conclusion, cyclical stocks rise and fall with the economic cycles, and investors should remain cautious when investing in them. In a growing economy, cyclicals can have higher than average gains, making them an attractive, yet more risky and time-consuming, investment.
Investing in cyclical stocks takes a lot of market analysis, experience, risk, and guessing, and there is no risk-proof way to do it. People can only attempt to predict the market and buy shares at a low point to sell them at a high point.
A combination of cyclical and defensive stocks is the best way to balance risk in your portfolio and makes sense for most investors. An index fund with a diversified collection of stocks could make the most sense to any new investors who are just getting started.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about cyclical stocks
What are cyclical stocks?
Cyclical stocks are securities that are heavily affected by the economic cycles and follow the ups and downs of the overall economy. Cyclicals are usually discretionary products like luxury clothing, furniture, cars, or non-essential services like vacations, travel, and eating out in restaurants. When the economy is up, the prices and spending on discretionary products and services also grows. When the economy is down, the prices of cyclical products and services also decrease, affecting the stock prices.
Why do people invest in cyclical stocks?
Cyclical stocks are an attractive investment opportunity because of their higher-than-average returns. The most significant advantage of cyclicals is that when the economy is prospering, they can offer higher growth opportunities compared to defensive stocks.
What are cyclical industries?
Cyclical stocks can be categorized as durables, nondurables, and services and are usually stocks in specific industries. Some examples of cyclical industries include sectors that are highly affected by fluctuations in consumer spending – restaurants and hospitality, travel and airlines, car manufacturers, construction, real estate, furniture, or luxury retail—any industry, where consumers are more likely to stop spending in and are considered non-essential.
How to invest in cyclical stocks?
Investing in cyclicals is about managing expectations; the prices can rise and fall suddenly as the economic conditions change. Even though investing in stocks can be risky, some types are more volatile and unpredictable than others.
There is no one-size-fits-all approach when investing in cyclical stocks. Still, there are things to keep in mind, such as diversifying your portfolio, doing your analysis and research on a case-by-case basis, and having a high-risk tolerance.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
