What are cyclical stocks?
Cyclical stocks are the types of stocks that are affected by macroeconomic factors, that is, systematic changes in the overall economy. In other words, they are company shares that fluctuate in correlation with the general economy. These stocks are known for following the phases of the business cycle through expansion, peak, recession, and recovery. Most cyclical stocks involve companies that sell discretionary items that consumers buy more during an economic boom but spend less on during a recession. Their value rises when the economy grows and on the other hand, when the economy contracts, these stocks undergo correction.
Examples of companies with cyclical stocks are car manufacturers, airlines, furniture retailers, clothing stores, restaurants, and hotels. If there is a severe recession in an economy, cyclical stocks may become worthless and the companies go out of business. Therefore, the securities of these discretionary companies are cyclical in nature.
The profits of these companies are on a rise during an economic boom because consumers have more disposable income to spend on such products. During an economic shutdown, on the other hand, their profits decline during an economic downturn as consumers cut down their spending. Because cyclical stocks are based on people’s wants, they are highly speculative as most of these companies do not provide essential goods and services. Their stock value can easily be overvalued. Although opportunist investors are being provided with a lot of profit opportunities, it is generally viewed as a bad thing.
It is critical for investors to be very careful about their positions in cyclical stocks but should not avoid them altogether. In other words, investors should be cautious about the weight of cyclical stocks in their portfolio at any given point in time but this fact does not mean that they should steer clear of these stocks completely. These stocks may rise and fall within the business cycle. This means that the movement of these stock prices is seemingly predictable which may force some investors to time the market. Here, they buy the shares when the business cycle is at its low point and sell them at a high point.
We can view cyclical stocks as more volatile than noncyclical or defensive stocks which tend to be more stable during periods of economic downturn. However, they offer greater growth potential because they tend to outperform the market in periods of economic expansion and strength. Investors that are seeking long-term growth with managed volatility tend to balance their portfolios with a combination of cyclical and defensive stocks.
Cyclical stocks examples
- The automobile industry stocks
- Airline stocks
- Tourist attractions and hotel stocks
The automobile industry stocks
The stocks of car manufacturers are cyclical in nature as they respond to economic trends. When the economy is doing well, more people can afford to buy new cars. On the other hand, when the economy begins to recede, then fewer people will afford to buy cars. As the economy gets worse, the first things that consumers cut are these discretionary expenses
Another cyclical stock is airline stock. It is more difficult for people to travel when the economy is in its recession or depression phase. This is because most people are focused on essential goods and services or necessities. Therefore, they cut down extravagant travels. On the other hand, if the economy is booming, many will afford to travel for the summer holidays, Christmas, etc.
Tourist attractions and hotel stocks
Spending on tourist attractions and lodging in hotels fall under discretionary expenses. Therefore, people tend to find other alternatives during economic downturns.
Advantages of cyclical stocks
- Massive growth
- Stimulus during falling interest rates
- More volatile than the benchmark
- Reflects business sentiment
When the economy is booming, cyclical stocks tend to provide massive growth to investors. Here, the value of such stocks shoots up as they reflect the increased confidence the consumers have in such companies during economic growth. When investors right buy before the economy begins to boom, it generates high returns. If the investor can identify the period just before the economy starts booming, he can gain a lot. In this case, timing matters while picking such stocks and the ability to make the right move just before the economy begins to boom and then manage to buy such stocks at the bottom of the business cycle, which would go on to experience an upturn. There will be a significant gain.
Stimulus during falling interest rates
During a fall in the interest rates in an economy, these stocks tend to have better valuations. When interest rates fall, earnings will increase to an extent. It is further reflected in the stock price. Therefore, in economies where such interest rates are falling, cyclical stocks experience a massive boost and then investors tend to make a lot of money in such cases.
More volatile than the benchmark
There are times that these cyclical stocks will be more volatile than the benchmark indexes. This will suggest that if an investor is able to time his purchases and investment in an industry that heavily depends on the country’s economic strength, he would sometimes be able to generate returns above the benchmark index of the particular country.
Reflects business sentiment
We can consider cyclical stocks to be a reflection of business sentiment in the economy. Therefore, one can gauge where the economy is heading by very well having an understanding of the movement of such cyclical stocks. They tend to rise during economic expansion and decline gradually during the recession phase. With this, they are a mirror of the business cycle and the sentiments prevailing in the economy.
Disadvantages of cyclical stocks
- Major fall during a recession
- Timing matters
- High volatility
- Major fall during a recession
- Requires careful analysis
- Erodes the holdings of passive investors
Major fall during a recession
Because cyclical stocks tend to be a reflection of the country’s business cycles, they do experience a significant fall in value during periods of recession. Investors who are unable to sell their stocks before the beginning of economic decline will have to bear a lot of losses that will result from a fall in the stock prices.
For such stocks, the timing during which an investor buys them matters a lot. If one makes the mistake of having to purchase them when the economy begins to slide down and later sell them when the economy is at its bottom, it will be greatly disastrous. Before one buys cyclical stocks, a careful analysis is required.
The fact that cyclical stocks are volatile is a major disadvantage. With the current conditions that are prevalent in the economy, they tend to fluctuate. Sometimes, they may go too far from the current levels and benchmarks and even head downwards even more than the levels at which the current benchmark would tend to be.
Requires careful analysis
Due to their volatile nature, cyclical stocks require careful analysis and understanding. It becomes essential that one always follows the markets and is much aware of the upcoming signs. It is only when one is able to dedicate sufficient time to follow the market that he would know and understand the trends. From there, he would decide when to enter and when to exit the market to take advantage of the market movement and business cycles.
Erodes the holdings of passive investors
Generally, long-term investors tend to be passive and do not engage in regular buying and selling. They do not bother themselves with following the markets frequently. They believe in having to buy right and sit tight. Now, when the economy is experiencing a downturn and a long-term investor holds cyclical stocks, the value of his holdings becomes eroded due to the fluctuating nature of cyclical stocks. It is therefore advisable for long-term and passive investors to wait for seven to ten years before the economy begins to recover from the downfall. However, if they are very well and reasonably diversified, there will be no need.
How to identify cyclical stocks
There are several indicators based on which one can judge whether a stock is cyclical or not. The first indicator is the Beta value or systemic risk. Cyclical stocks tend to have high Beta values which are usually greater than 1. For example, a Beta of 1.5 implies that if the market falls 10 percent, there is a likelihood for the stock to fall 15 percent.
The second indicator is that cyclical stocks tend to have volatile earnings per share (EPS) since their earnings fluctuate in relation to the sentiment of the economy
The price-to-earnings ratio is the third aspect as it compares the price of a stock in relation to its earnings per share. Generally, cyclical stocks tend to have low PE ratios which makes them cheaper in comparison to defensive stocks.
What are examples of cyclical stocks?
Examples of companies with cyclical stocks are automobile industries, airlines, furniture retailers, clothing stores, restaurants, and hotels. Consumers tend to cut their expenses on the goods and services of these companies during economic downturns and focus on essential goods. The stocks of these companies are cyclical as they respond to economic changes. Their value rises when the economy booms and falls when the economy is in a recession.
Is it good to invest in cyclical stocks?
Timing matters a lot when it comes to investing in cyclical stocks. Cyclical stocks possess value only when there is an economic boom. So it will be disastrous for one to make the mistake of investing in such stocks when the economy is at the beginning of a recession. If you are not able to sell your stocks before the economy starts to fall, then you are in for a huge loss.
Are the stocks of banks cyclical?
The stocks of banks are cyclical in nature, especially for commercial banks as they lend money to individuals through loans, credit cards, and mortgages. The demand for these services increases during periods of economic growth and decreases during economic declines. Therefore, the banking sector is cyclical in nature.