There is no crystal ball that tells you when a stock price is going to rise or fall; but there are stocks that follow the cycles of the economy, thus making their movement easier to predict. These securities are called cyclical stocks and are impacted by the overall economy, consumer demands, and discretionary spending.
When the economy is booming, this type of stock begins growing. However, when consumer demand or the economy is low, the performance of this type of stock is also low.
What Is the Purpose of Cyclical Stocks?
These type of stocks are one of the more volatile stocks on the market. They perform well when the economy is booming, but during downturns like a recession, they can see major losses. This type of stock is dependent on the habits of consumer spending.
Think of things that are considered non-essential that are the first things people cut when the economy does poorly – like that early morning trip to Starbucks or traveling to their favorite resort.
Characteristics of Cyclical Stocks
As aforementioned, cyclical stocks rise and fall with consumer spending during cycles of the economy. While cyclical stocks are found across various industries they all have a few common characteristics:
- Affected by economic changes
- Discretionary companies that are non-essential
- Includes a range of businesses from small to well-established
- High volatility
Types of Cyclical Stocks
These type of stocks are found across multiple industrial sectors. While this is not a full list of all the industries that follow the economy’s cycle, it provides you with a good illustration.
The important thing to remember with cyclical stocks is that they rise and fall with the economic cycle, but that does not mean that there is full predictability of the exact movement. If a recession is bad enough, some non-essential companies can go out of business, rendering the these types of stock worthless.
Durable goods are considered “hard goods,” meaning they should not wear out over time.
Automobiles: When the economy is down, consumers tend to put off buying new vehicles, doing additional maintenance, replacing tires, and even driving if it is not necessary – like we saw during the COVID pandemic.
Household durables: This category includes furniture, electronics, appliances, and other household items that are hard to justify purchasing during tough economic times.
Real Estate: Real estate is also impacted by the economy. New construction, property developers, commercial investors, and consumer purchases tend to get put on pause when the economy declines.
Non-durable goods are also called “soft goods.” These are items that are used or consumed immediately or have a lifespan less than three years.
Textiles and apparel: Typically, clothing and accessory designers, especially expensive brands, are the first to take a hit during a recession.
Cosmetics: Cosmetic brands also see disruptions during economic challenges. From consumers staying home wearing less makeup, to just cutting back due to tightened budgets, this industry is impacted during downturns.
The final type of cyclical stock is services. This category includes restaurants, hotels, airlines, and other forms of entertainment.
Dining and Hospitality: While eating is essential, having your dollar go further is more of a priority during a bad economy. Eating out is much more expensive than staying home to cook, which is why it takes a toll during economic challenges.
Travel and entertainment: When times are tough, consumers spend on needs, not wants. While everyone would love to go to a luxury resort, take a cruise, attend a concert, or view the latest movie in the theater, when the economy is down, this sector takes a hit.
Benefits and Drawbacks of Cyclical Stocks
Before investing in any stock, you should understand the benefits and drawbacks. After all, no investment is perfect, but understanding what you are investing in will help guide your decisions.
The benefits of cyclical stocks include:
Diversification: When you mix both these type of stocks with non-cyclical stocks, you have a portfolio strategy that can grow rapidly during a strong economy. In addition to remaining stable during economic downturns.
High performance: In times that the economy is growing, these stocks tend to outperform the stock market.
Bargains: These stocks depend highly on economic trends. You can utilize this knowledge to purchase a stock that lost value during a recession, hoping it will have a high rebound with the market.
There are, of course, drawbacks associated with cyclical stocks. This includes:
High volatility: While you can see high performance during times of growth, you also are subject to substantial falls. The performance of your cyclical stocks can have drastic changes from quarter to quarter.
Dependent on economy: There is no pattern of when the economy is going to fall, or even when it will rebound. The success of your stock follows the pattern of the falls, rises, and rebounds of the economy.
Timing: Buying and selling cyclicals require you to make smart decisions to buy low and sell high before prices take a turn again.
Cyclical vs Non-Cyclical Stocks
While these stocks follow the economy, non-cyclical stocks (also called defensive stocks) continue to be strong during economic downturns.
Non-cyclical stocks encompass consumer staples that they will continue to use regardless of the economy. Companies that provide groceries, utilities, healthcare, and other consumer staples fall into this category. While they are not fully considered “recession proof” they will not fall as far or as fast as cyclical stocks.
How Do Investors Try to Find Cyclical Stocks?
If you are ready to start investing in cyclical stocks, the first place you should start is by identifying the industries you would like to invest in. As mentioned above, cyclical stocks cross multiple industries. Here are examples from each that can help you on your way:
Automobiles: General Motors (NYSE: GM)
Household durables: Wayfair (NYSE: W)
Real Estate: Invitation Homes (NYSE: INVH)
Textiles and apparel: Moet Hennessy Louis Vuitton (OTC: LVMHF)
Cosmetics: Ulta Beauty (NASDAQ: ULTA)
Dining and Hospitality: Texas Roadhouse (NASDAQ: TXRH)
Travel and entertainment: Southwest Airlines (NYSE: LUV)
You can also explore your options with an exchange-traded fund (ETF). This financial vehicle allows investors to select a sector or industry they would like to invest in, without having to purchase individual securities.
Adding Cyclical Stocks to Diversify Your Portfolio
Cyclical stocks are a great way to diversify your portfolio to see gains that outperform the market. Staying on top of economic trends and making quick moves is necessary when you invest in cyclical stocks. To utilize them correctly, they should be part of a broader investment strategy within your portfolio.
Your financial advisor can provide you with strategies to get the most out of cyclical stocks, while also recommending non-cyclical stocks that can help you balance your portfolio properly.