Cyclical investing means understanding how various stock sectors react to economic changes. A cyclical stock is one that’s closely correlated to what’s happening with the economy at any given time. The performance of non-cyclical stocks, however, is typically not as closely tied to economic movements.
Investing in cyclical stocks and non-cyclical stocks may help to provide balance and diversification in a portfolio. This in turn may help investors to better manage risk as the economy moves through different cycles of growth and contraction.
Cyclical vs Non-Cyclical Stocks
|Cyclical Stocks||Non-Cyclical Stocks|
|Perform Best During||Economic growth||Economic contraction||Goods and Services||Non-essential||Essential|
|Sensitivity to Economic Cycles||Higher||Lower|
A cyclical investing strategy can involve choosing both cyclical and non-cyclical stocks. In terms of how they react to economic changes, they’re virtual opposites.
Cyclical stocks are characterized as being:
• Strong performers during periods of economic growth
• Associated with goods or services consumers tend to spend more money on during growth periods
• Highly sensitive to shifting economic cycles
• More volatile than non-cyclical stocks
When the economy is doing well a cyclical stock tends to follow suit. Share prices may increase, along with profitability. If a cyclical stock pays dividends, that can result in a higher dividend yield for investors.
Non-cyclical stocks, on the other hand, share these characteristics:
• Tend to perform well during periods of economic contraction
• Associated with goods or services that consumers consider essential
• Less sensitive to changing economic environments
• Lower volatility overall
A non-cyclical stock isn’t 100% immune from the effects of a slowing economy. But compared to cyclical stocks, they’re typically less of a roller-coaster ride for investors in terms of how they perform during upturns or downturns. A good example of a non-cyclical industry is utilities, since people need to keep the lights on and the water running even during economic downturns.
In the simplest terms, cyclical stocks are stocks that closely follow the movements of the economic cycle. The economy is not static; instead, it moves through various cycles. There are four stages to the economic cycle:
• Expansion. At this stage, the economy is in growth mode, with new jobs being created and company profits increasing. This phase can last for several years.
• Peak. In the peak stage of the economic cycle, growth begins to hit a plateau. Inflation may begin to increase at this stage.
• Contraction. During a period of contraction, the economy shrinks rather than grows. Unemployment rates may increase, though inflation may be on the decline. The length of a contraction period can depend on the circumstances which lead to it.
• Trough. The trough period is the lowest point in the economic cycle and is a precursor to the beginning of a new phase of expansion.
Understanding the various stages of the economic cycle is key to answering the question of what are cyclical stocks. For example, a cyclical stock may perform well when the economy is booming. But if the economy enters a downturn, that same stock might decline as well.
Examples of Cyclical Stocks
Cyclical stocks most often represent things that consumers spend money on when they have more discretionary income.
For example, that includes things like:
• Entertainment companies
• Travel websites
• Retail stores
• Concert promoters
• Technology companies
• Car manufacturers
The industries range from travel and tourism to consumer goods. But they share a common thread, in terms of how their stocks tend to perform during economic highs and lows.
Cyclical Stock Sectors
The stock market is divided into 11 sectors, each of which represents a variety of industries and sub-industries. Some are cyclical sectors, while others are non-cyclical. The cyclical sectors include:
The consumer discretionary sector includes stocks that are related to “non-essential” goods and services. So some of the companies you might find in this sector include those in the hospitality or tourism industries, retailers, media companies and apparel companies. This sector is cyclical because consumers tend to spend less in these areas when the economy contracts.
The financials sector spans companies that are related to financial services in some way. That includes banking, financial advisory services and insurance. Financials can take a hit during an economic downturn if interest rates fall, since that can reduce profits from loans or lines of credit.
The industrials sector covers companies that are involved in the production, manufacture or distribution of goods. Construction companies and auto-makers fall into this category and generally do well during periods of growth when consumers spend more on homes or cars.
The tech sector is one of the largest cyclical sectors, covering companies that are involved in everything from the development of new technology to the manufacture and sale of computer hardware and software. This sector can decline during economic slowdowns if consumers cut back spending on electronics or tech.
The materials sector includes industries and companies that are involved in the sourcing, development or distribution of raw materials. That can include things like lumber and chemicals, as well as precious metals. Stocks in this sector can also be referred to as commodities.
Recommended: Commodities Trading Guide for Beginners
Cyclical Investing Strategies
Investing in cyclical stocks or non-cyclical stocks requires some knowledge about how each one works, depending on what’s happening with the economy. While timing the market is virtually impossible, it’s possible to invest cyclically so that one is potentially making gains while minimizing losses as the economy changes.
For investors interested in cyclical investing, it helps to consider things like:
• Which cyclical and non-cyclical sectors you want to gain exposure to
• How individual stocks within those sectors tend to perform when the economy is growing or contracting
• How long you plan to hold on to individual stocks
• Your risk tolerance and risk capacity (i.e. the amount of risk you’re comfortable with versus the amount of risk you need to take to realize your target returns)
• Where the economy is, in terms of expansion, peak, contraction, or trough
For example, swing trading is one strategy an investor might employ to try and capitalize on market movements. With swing trading, you’re investing over shorter time periods to reap gains from swings in stock prices. This strategy relies on technical analysis to help identify trends in stock pricing, though you may also choose to consider a company’s fundamentals if you’re interested in investing for the longer term.
One way to simplify cyclical investing is to choose one or more cyclical and non-cyclical exchange-traded funds (ETFs). Investing in ETFs can simplify diversification and may help to mitigate some of the risk of owning stocks through various economic cycles.
Recommended: How to Trade ETFs: A Guide for Retail Investors
Cyclical stocks tend to follow the economic cycle, rising in value when the economy is booming, then dropping when the economy hits a downturn.
If you’re ready to try cyclical investing, an online brokerage account can help you purchase individual cyclical stocks and others, bonds, ETFs, and other securities. With SoFi Invest, it’s possible to get started investing with as little as $5 and start building a well-rounded portfolio.
Photo credit: iStock/Eoneren
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