What are cyclical stocks?

Cyclical stocks tend to rise and fall with the general economic cycle. Their revenues and profits typically rise swiftly during economic expansions and fall sharply during recessions. Many cyclical stocks are negatively impacted by consumers who find it necessary to reduce discretionary spending during downturns in the economy.

What companies and industries are considered cyclical?

One way to help you understand what companies and industries are considered cyclical is to think about them in terms of needs and wants. Oftentimes, cyclical companies sell products or services that fall more in the want category, such as restaurants or those that sell fashion goods or home improvement. When economic downturns occur, these types of purchases can easily be put off until the economy improves, causing businesses in these industries to suffer in the meantime.

Other businesses considered cyclical would be airlines, hotels and anything tied to travel. Certain types of manufacturing are also affected during recessions as businesses pull back on investment in response to the decline in demand. The semiconductor industry has often experienced cyclicality that can impact the level of demand as well as prices for computer chips, making the results of some semiconductor companies especially volatile.

While some cyclical businesses see their profits decline or eliminated altogether, other businesses face even worse outcomes during recessions. Cyclical companies with heavy debt loads are sometimes forced into bankruptcy during economic downturns. The airline industry, for example, has suffered several bankruptcies in recent decades as slowdowns meant some businesses couldn’t meet their debt obligations.

Defensive stocks

You might think that most businesses suffer during economic slowdowns, but there are some that seem to plod ahead no matter the macroeconomic environment. These businesses, and therefore stocks, are sometimes referred to as being “defensive,” and they include consumer products companies that sell essential consumer goods ranging from laundry detergent to toilet paper and diapers. These companies are considered non-cyclical because their demand isn’t impacted much by the broader economic environment.

These products fall more in the “need” category. You probably buy the same amount of toilet paper or laundry detergent during a recession as you do during an economic boom. Some businesses might even see their businesses boosted during recessions. Walmart (WMT) has been known to see a sales boost during downturns as shoppers look to save money on regular purchases like groceries and other essentials.

Defensive stocks often have a long history of paying dividends, which can be a great way for investors to build wealth over time.

How investors can benefit from cyclical stocks

Some investors like to trade in and out of cyclical stocks as the businesses rise and fall with the economy. This is easier said than done, but if you’re able to time your purchases well it can lead to outsized investment gains.

The strategy involves buying cyclical stocks near the low point in the economic downturn when the companies are close to their earnings trough. This is difficult in a few ways. First, it’s not always clear when the economy is bottoming out. Things can always get worse before they get better. Second, it will likely be emotionally difficult to commit your hard-earned money to an investment when economic conditions are at their worst.

Another challenging part of this strategy is that you’ll likely be buying when popular valuation metrics like the price/earnings (P/E) ratio appear high. For example, if a business earned $0.10 per share over the past twelve months and its stock sells for $10.00, the P/E ratio will look extremely high at 100. But if that same business is about to recover with the broader economy and will earn $1.00 per share in the next year or two, you may have quite the bargain on your hands.

The reverse is true at economic peaks. A cyclical business earning $10.00 per share with a stock selling for $100 might look like a deal at 10 times earnings, but if its earnings are about to collapse to $1.00 per share in the next 12-18 months, it may be a very expensive stock. You’ll want to have a strong understanding of cyclical businesses before you start investing in this area.

Bottom line

Cyclical stocks see their business results rise and fall with the broader economic cycle. Investors should be careful wading into this volatile area, but the returns can be big if investments are well-timed. A combination of cyclical and defensive stocks will likely make sense for most investors, and investors just getting started may opt for an index fund based on the S&P 500, which includes a diversified collection of stocks.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.