Examples, Risks, and Growth Opportunities
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What Is a Cyclical Stock?
Cyclical stocks, which include car manufacturers and airlines, rise and fall in sync with the economic cycle. During economic expansion, these companies often see increased sales as consumers spend more on discretionary items. Conversely, in recessions, their stock prices can plummet as spending contracts. Investors looking at cyclical stocks should be aware of their volatility and the potential for higher returns during periods of economic strength.
Key Takeaways
- Cyclical stocks rise and fall in value with the economic cycles of expansion, peak, recession, and recovery.
- Companies in the automobile, airline, and retail sectors commonly represent cyclical stocks due to their sensitivity to economic changes.
- Cyclical stocks are generally more volatile than noncyclical stocks, but they potentially offer higher returns during periods of economic strength.
- To mitigate risks due to economic downturns, investors often diversify portfolios by balancing cyclical stocks with noncyclical ones, like consumer staples.
- Exchange-Traded Funds (ETFs) can provide a convenient way for investors to gain exposure to cyclical stocks during economic booms.
Investopedia / Michela Buttignol
How Cyclical Stocks Respond to Economic Changes
Cyclical stocks come from companies like car manufacturers, airlines, furniture retailers, clothing stores, hotels, and restaurants. Consumers can afford to buy new cars, upgrade their homes, shop, and travel when the economy is doing well.
These discretionary expenses are some of the first things consumers cut when an economy does poorly. In a severe recession, cyclical stocks can become worthless, and companies may go out of business.
Important
Investors should be careful about their positions in cyclical stocks but they shouldn’t avoid them entirely.
Cyclical stocks move with the economic cycle. Their predictable price changes may lead investors to try timing the market. Investors buy these shares at low points and sell them at high points in the business cycle.
Investors should use caution about the weight of cyclical stocks in their portfolios at any point in time but this doesn’t mean investors should steer clear of these stocks completely.
Risks and Benefits of Investing in Cyclical Stocks
Cyclical stocks are seen as more volatile than noncyclical or defensive stocks, which tend to be more stable during periods of economic weakness. However, they offer greater potential for growth because they tend to outperform the market during periods of economic strength. Investors seeking long-term growth with managed volatility tend to balance their portfolios with a mix of cyclical stocks and defensive stocks.
During economic expansions, investors often use exchange-traded funds (ETFs) to invest in cyclical stocks. The SPDR ETF series offers one of the most popular cyclical ETF investments in the Consumer Discretionary Select Sector Fund (XLY).
Comparing Cyclical and Noncyclical Stocks
The performance of cyclical stocks tends to correlate with the economy but the same can’t be said about noncyclical stocks. These stocks tend to beat the market regardless of the economic trend, even when there’s a slowdown in the economy.
Noncyclical stocks are also known as defensive stocks. They encompass the consumer staples category with goods and services that people continue buying through all types of business cycles, even economic downturns.
Companies dealing with essentials like food, gas, and water, such as Walmart, have noncyclical stocks. Adding noncyclical stocks to a portfolio can be a great strategy for investors because it helps hedge against losses sustained by cyclical companies during an economic slowdown.
Examples of Cyclical Stocks by Industry
Cyclical stocks are further categorized into durables, nondurables, and services. Durable goods companies are involved in the manufacture or distribution of physical goods that have an expected life span of more than three years. Companies that operate in this segment include automakers such as Ford, appliance manufacturers like Whirlpool, and furniture makers such as Ethan Allen.
The measure of durable goods orders is an indicator of future economic performance. It may be an indication of stronger economic activity in the ensuing months when durable goods orders are up in a particular month.
Nondurable goods companies produce or distribute soft goods that have an expected life span of fewer than three years. Examples of companies that operate in this sector are Coca-Cola and Procter & Gamble.
Services is a separate category of cyclical stocks because these companies don’t manufacture or distribute physical goods. They instead provide services that facilitate travel, entertainment, and other leisure activities for consumers. Walt Disney (DIS) is one of the best-known companies operating in this space. Also falling into this category are companies that operate in the digital area of streaming media, such as Netflix (NFLX).
How Can I Collect Income From Investing in Stocks?
A stock is essentially an ownership interest in a company. You own a small percentage of the enterprise when you purchase one or more of its stocks. You’ll receive monetary dividends as payment when and if the company does well. You can use them to reinvest and purchase more shares or you can take dividends as cash payments.
You can also sell your stocks. You’ll have capital gains income if you can sell your shares for more than your investment in them, including any trading fees.
What Are Some of the Best Cyclical Stocks?
The “best” of any type of stock is the one that most closely accommodates your goals and your risk tolerance. That said, numerous sources will rate individual stocks for you based on other factors. Yahoo Finance recommends cyclical stocks of companies with names that we’re all familiar with, like Costco, Expedia, UPS, Airbnb, and Kohl’s.
What Is a Counter-Cyclical Stock?
As the term “counter” implies, a counter-cyclical stock is noncyclical. Its price is inclined to move in the opposite direction from that in which the economy appears to be headed. The prices of these stocks tend to go up when the economy is struggling and a recession is looming or has already begun.
The Bottom Line
Cyclical stocks mirror the economic cycle, surging in times of prosperity and declining during recessions. Typically, these stocks belong to companies offering discretionary goods and services, such as restaurants and entertainment, which consumers splurge on in good times.
While cyclicals can yield high returns during economic booms, they come with increased volatility. Investors should consider balancing them with noncyclical, or defensive, stocks that remain stable through economic fluctuations. This strategy may help manage risk and potentially bolster growth in a well-diversified portfolio.
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