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What Are Cyclical Stocks?

UTC by John Caroline · 7 min read
What Are Cyclical Stocks?
Photo: Depositphotos

Stocks are one of the most vital financial instruments in the world today. Here’s a guide to provide a basic understanding of one of the most common types of stocks – cyclical stocks.

Among all the diverse types of stocks, cyclical stocks are those that are vulnerable to the economic situation at any given time, referring to the guide provided by Coinspeaker on stocks and it’s classifications.

The stock of a company is often regarded as cyclical when its price trends are easily affected by changes in economic situations at any time. In other words, their prices fluctuate alongside the overall economic situation which causes them to increase in price as at when the economy is said to be thriving or recovering from a rough phase. Thus, the reverse happens with stocks when the economic situation is becoming unfavorable.

It has been observed that cyclical stocks pose investors to higher risks in times of uncertain economic situations since they can be greatly challenged by unfavorable market conditions.

Cyclical Stocks Definition

Cyclical stocks are stocks that are readily and easily influenced by fluctuations in business cycles. The stock of a company is seen to be cyclical when its price rises in sympathy with a thriving economy or an economy that is gaining some measure of recovery from rough times and then declines when there’s a downturn in the economy or some signals of uncertainty.

In other words, prices of cyclical stocks go up during periods of rising inflation and growth in the economy, while they tend to drop or fall during periods of recessions and slowdown in the economy.

In strong economies, consumers have more disposable income, which results in increased consumer demand. This in turn engineers corporate profits and the rise in dividends paid to shareholders. During recessions, however, there is a fall in consumer demand, courtesy of the less disposable income available to individuals. Thus,  reducing corporate profits and in effect the prices of shares. These situations often result in a crash in the stock market.

Understanding Cyclical Stocks

A clear understanding of cyclical stocks provides the ability for investors to make an informed and effective prediction of the movements of stock prices of cyclical shares. Thus, a proper and in-depth understanding of the business cycle is pertinent. An optimistic pattern of spending and investment during periods of a boom in the economy is usually observed among residents of a particular nation.

Residents often tend to spend more on comfort and items of luxury, with relatively higher per capita incomes, which results in increasing the manufacturing companies’ profitability from the production of such items.

Consumer utility items like refrigerators, cars, air conditioning units, television, etc, are mostly found in this category. In periods of economic expansion, firms engaged in the production of such items highlighted, due to increased market demand for the items, experience the highest levels of growth in terms of profitability.

Also, the speculative demand limits of individuals are often increased by their higher spending capacity as they are willing to acquire a higher number of shares to strengthen overall stock market returns.

The profitability increase of such companies in addition to increased demand for corresponding shares increases the average prices of shares in the market. It further increases their revenue-generating capacity due to a cash flow increase.

In times of economic decline, however, companies with cyclical stocks are pretty much hit the hardest. Production capacity and rate, as well as employment levels, are affected by the economic slowdown that features recession. Usually, a rise in the level of unemployment leads to a fall in demand for consumer utility goods, prompting a significant fall in the generation of total revenue and corresponding level of profit. Under such an economic scenario, there is a plummet in the share prices of most cyclical stocks due to lower levels of production of such companies as well as lower stock demand in the trading market.

Therefore, the performance of cyclical stock and business cycle fluctuations is directly related, as an increase in the economic performance substantially increases the profitability of issuing companies, while a steep fall in the profitability of such businesses is caused by a downtrend of the business cycle.

Cyclical vs Non-Cyclical Stocks

Better investment strategy decisions are made with a good understanding of the different types of stocks. This includes knowing and understanding the difference between cyclical and non-cyclical stocks.

It’s quite important to note that to some degree, all investments are volatile. At any time, they could gain or lose value, unlike cash in a savings account. But some types of stocks are more stable than others.

Whereas cyclical stocks are sensitive to economic trends and cycles, non-cyclical stocks are more consistent through downturns in the economy and are not as much affected or influenced by economic downturns.

Sometimes called “defensive stocks”, non-cyclical stocks have a greater degree of stability, even when uncertainty is experienced in the economy. This in part is due to the fact that non-cyclical stocks generally provide essential non-discretionary goods like utilities and groceries.

Non-cyclical stocks cover the category of consumer staples, with goods and services that people continue to demand through all types of business cycles, even in economic downturns.

Companies in lines of the trade like food, water, and gas are ready examples of those that have non-cyclical stocks.

Cyclical Industries

Basically, companies that largely depend on disposable income fall into the category of cyclical stocks. Companies within industries such as travel, restaurant, entertainment,  leisure, retail technology, luxury, amongst a number of others, are found in the cyclical category.

Some of the common industries which are considered cyclical include:

  • Auto components manufacturing. In 2020, revenue for manufacturing auto parts dropped, with the rise in unemployment and a fall in consumer business spending due to the coronavirus outbreak.
  • Construction. Builders and materials providers in the housing market can be impacted by economic cycles and changes in trends.
  • Semiconductor. The wide swings and cyclical nature of the semiconductor industry are mostly caused by the relatively short lifespan of items of technology.
  • Airlines. Airline stocks are most likely to witness an improved performance, as people have more money to spend on non-essentials like travel.
  • Hotels, restaurants, and leisure.
  • Textile, apparel, and luxury goods. In times of economic boom, luxury goods do well, while people limit their purchase of clothing when the recession hits.

Pros and Cons of Cyclical Stocks

The major merit to cyclical stocks is the potential for growth in periods of economic growth, given that it moves in sympathy with the economic trend.

Although cyclical stocks drop in times of economic downturns, those with the right tolerance for risk could still benefit or gain an advantage.

One of the biggest disadvantages with the attempt of investing in cyclical stocks is that it encourages investors to engage in behavior that resembles market timing. It is practically not possible to time the stock market or be certain about what a stock will do from one day to the other.

Another major disadvantage is that cyclical stocks are very volatile. They tend to fluctuate a lot with the prevailing economic condition and may sometimes go too far from the current levels and benchmark.

In addition, based on the fact that cyclical stocks are volatile, careful analysis and better understanding are necessary. This requires one to be consistent in following the market and being aware of any signs ahead. Such a consistent update requires the commitment of time which could pose a strain at some point.

Conclusion

Among all the diverse types of stocks, cyclical stocks are those that are vulnerable to the economic situation at any given time. However, a strategic and focused investor can take advantage of the cycle by buying during the periods of rising and selling when things change.

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FAQ

What are cyclical stocks?

Cyclical stocks are stocks whose performance follows the economic trend by rising when there is economic growth and declining when there is an economic downturn.

What are the most cyclical sectors?

The most cyclical sectors include basic materials production, financial services, and real estate.

What is the difference between cyclical and non-cyclical stocks?

Cyclical stocks are sensitive to economic trends and cycles, while non-cyclical stocks are more consistent all through downturns in the economy and are not as so much affected or influenced by economic downturns.

What are the advantages of cyclical stocks?

Cyclical stocks have the potential for growth in periods of economic growth, given that it moves in sympathy with the economic trend.

What are the disadvantages of cyclical stocks?

Trying to invest in cyclical stocks encourages investors to engage in behavior that resembles market timing, whereas it is practically not possible to time the stock market or be certain about what a stock will do from one day to the other.

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