Cyclical Stocks - What You Should Know

Tuesday, August 31, 2021 | Chris Markoch
Cyclical Stocks - What You Should Know

For some younger investors, the global pandemic was their first experience with a bear market (no matter how briefly it lasted). Since the financial crisis of 2007-2008, the stock market has been in a bull market. However, as most investors are quick to point out, this has been an extraordinary cycle for stocks. And one concept the pandemic reawakened was the concept of cyclical stocks.

As their name implies, cyclical stocks are stocks that move up and down in a somewhat predictable cycle. When the economy is strong and growing, these stocks tend to outpace the market. However, the opposite is also true. When the market is weak and contracting, these stocks will have larger declines.

Cyclical stocks are frequently linked with consumer behavior. Airlines, hotels, cruise lines, and restaurants were among the stocks that were hardest hit at the onset of the pandemic. And even as the economy was recovering, these stocks didn’t immediately bounce back to their pre-pandemic highs.

Despite the risk associated with cyclical stocks, these are for the most part mature companies that, in some cases, pay a dividend to promote shareholder value. This is what sets them apart from other pure growth stocks where the underlying business may be put at risk during an economic downturn.

Introduction

Cyclical stocks are stocks of those companies that move with a high correlation to the broader economy. When the economy is in an upturn and performing well, these stocks tend to be the beneficiary of that growth. Conversely when the market is in a downturn and growth is slowing (particularly when consumer spending is dropping), these stocks will lag behind the broader market.

Used strategically, cyclical stocks can help investors generate returns that outperform the market when the economy is going good.

The opposite of cyclical stocks is defensive stocks. Defensive stocks are those stocks that perform about the same regardless of conditions in the broader economy. Typically defensive stocks are found in companies that have products and/or services that consumers and businesses will continue to buy regardless of economic conditions. Utility companies are one of the most well-known forms of cyclical stocks.

In this article, we’ll take a closer at look at cyclical stocks including defining the different categories of cyclical stocks and highlighting the benefits and the risks of investing in these stocks. We’ll also look at how investors can manage that risk.

Understanding Cyclical Stocks

One of the best ways to understand the risk/reward nature of cyclical stocks is as the opposite of non-cyclical (or defensive) stocks. In this case, the word “essential” comes to mind. Non-cyclical stocks tend to be companies that have products or services that consumers and businesses deem essential.

For example, General Mills (NYSE: GIS) is one of the best-in-class among defensive stocks. The company is known for its cereal brands including Cheerios, that consumers will continue to buy even as they cut other items out of their budget.

On the other hand, cyclical stocks are companies that have products and services that are more discretionary in nature. These companies tend to outperform the market when the economy is going strong, but will underperform when the market is weaker. Starbucks (NASDAQ: SBUX) is a good example of a cyclical stock.

Cyclical Stocks Follow the Business Cycle

The reason why cyclical stocks are “cyclical” is because they follow the business cycle. For example, when a business is growing they engage in expansionary activity. They purchase new equipment and hire new workers. They may build or update facilities; they will devote money to research and development. All of these are things that businesses do when they are generating (or believe they are going to generate) higher revenue and, ideally, higher profits.

Conversely, these companies will pull back on spending when the economy slows down. They freeze hiring and may even let go of some workers. They hold off on capital expenditures.

Some cyclical stocks fit into the category of consumer discretionary stocks. These companies, like automakers and furniture manufacturers, rely on consumer spending. When consumers are feeling confident about their discretionary income, they are more likely to make larger purchases. They’re also more likely to eat out and book vacations.

But when confidence wanes, the products and services of these companies are the first to get cut out of the budget. And that means the company’s revenue and profits take a hit.

That was why significant events such as the financial crisis in 2007 and the pandemic in 2020 cause these cyclical stops to drop. They are disruptions to commerce.

Categories of Cyclical Stocks

The three primary categories of cyclical stocks are durable goods, nondurable goods, and services. Here’s a quick breakdown of each category.

  • Durable goods – These companies manufacture and distribute physical goods that have a lifespan of at least three years. Automobile manufacturers fit into this category as do appliance manufacturers and furniture makers. In some cases, these items are duress purchases. But, in general, these are “big ticket” items for which consumers and businesses plan and save. This puts them in the category of cyclical stocks as consumers and businesses may choose to delay their planned purchases if they are concerned about the economy.

Durable goods are considered a leading indicator because the direction of durable goods in a particular month can be a signal of future strength or weakness in the broader economy. In other words, if consumers and businesses are buying more durable goods, it means they are bullish on the health of the economy.

  • Nondurable goods – These companies manufacture “soft goods,” which have an expected life span of less than three years. Apparel companies such as Nike (NYSE: NKE) are a good example of a nondurable goods company as are retail stores such as Kohl’s (NYSE: KSS) or Target (NYSE: TGT). Retail sales, in fact, are one of the most closely watched economic reports because it is closely tied to consumer sentiment.

  • Services – These companies don’t manufacture physical goods. Rather they provide services that facilitate entertainment, travel, or other leisure pursuits. Airlines, hotel chains, and cruise lines are good examples. In the age of the internet, digital media companies such as Netflix (NASDAQ: NFLX) are becoming a cyclical stock. For this reason, Disney (NYSE: DIS) is one of the biggest of cyclical stocks because it covers both travel and streaming video.

What are the benefits of investing in cyclical stocks?

The primary benefit to investing in cyclical stocks is that investors can ride the hot hand. When the economy is going strong, a cyclical stock tends to ride that wave to completion. That means investors can still get strong growth even if they miss the initial upswing in the stock.  

Another benefit with many cyclical stocks is that they pay a dividend. Many of these companies have been around for a long time and have a business model that helps to generate strong cash flow. This cash is then returned to shareholders by way of a dividend. These dividends do not typically have a high dividend yield. However, the reason investors should be interested in these stocks is because of the consistency with which they pay out – and increase – their dividends. In fact, several of these companies are on the Dividend Aristocrat list. This is an elite list of companies that have increased their dividend for at least 25 consecutive years.

What are the risks of investing in cyclical stocks?

Investing in cyclical stocks is a variation of market timing. And whenever investors engage in market timing it means that they are choosing one investment at the exclusion of others, which may cause them to miss out on gains.

How can investors manage the risk of cyclical stocks?

One of the easiest ways to maintain exposure to cyclical stocks while still managing downside risk is to invest in an exchange-traded  fund that focuses on cyclical stocks. One of the best-in-class options is the Invesco S&P 500 Equal Weight Consumer Discretionary ETF (NYSEARCA: RCD). This is an “equal weight” fund which means of the fund’s 60 holdings no one position is more than 1.9% of the entire fund’s holdings at that time. While this means you may miss out on some growth if any of the individual components breaks out, but it’s a strategy that, over time, proves itself to be smoother and less volatile.

The last word on cyclical stocks

Cyclical stocks feature price movement that has a high correlation with the broader economy. When the economy is growing and expanding, these stocks tend to outperform the market. However, when the economy is slowing and contracting, these stocks tend to underperform the market.

This opportunity for market-beating growth puts these stocks in the category of offensive stocks. However, like any asset class, cyclical stocks are best used in moderation. A portfolio that is excessively weighted with cyclical stocks will not be well-diversified in times when economic conditions are working against those companies.


7 Clean Energy Stocks to Buy As Climate Change Initiatives Heat Up

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View the "7 Clean Energy Stocks to Buy As Climate Change Initiatives Heat Up".


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