Cyclical Stocks

What Is a cyclical stock?

Cyclical stocks watch their share prices rise and fall at the discretion of consumers. Cyclicality refers to the correlation of a company’s profitability and its related stock price with the movement of the economy.

When the economy is expanding or recovering from a recession, share prices of cyclical stocks rise reflecting the improving prospects of the cyclical companies; when the economy is contracting, share prices of cyclical stocks fall as investors rotate out of cyclical stocks and into defensive stocks or growth stocks. Cyclical stocks’ in-step movement with the economy is a called a positive correlation.

To imagine a cyclical stock, think of how you spend your discretionary money. Cyclical stocks are also called consumer cyclicals and merit their own market sector. Industries within this sector include auto and truck manufacturers; hotels, motels and cruise lines; restaurants and bars; most retailers; and home furnishings.

Banks are not considered cyclical stocks in the sense of being part of the consumer cyclicals sector. However, banks and other financial services companies, such as insurance providers, do see their business prospects change under different economic pressures. An oil and gas exploration and production company, such as Occidental Petroleum (OXY), is an example of a stock that is part of a sector (energy) that is subject to intra-sector cycles based on supply and demand.

Non-cyclical stocks have no correlation between their profitability and the economy. The goods and services non-cyclical stocks have what is referred to as “sticky” demand. Consumers need the products these companies provide no matter what the condition of the economy is. Non-cyclical stocks are also called defensive stocks.

For investors, non-cyclical stocks are defensive because they do not see their share prices as weak on a relative basis under recessionary pressure. Conversely, non-cyclical share prices do not jump during economic expansion the way cyclical stocks do. Defensive stocks include food manufacturers and processers such as Tyson Foods Inc. (TSN), personal products manufacturers such as Procter & Gamble Co. (PG) and utilities companies.

Counter-cyclical stocks are the inverse of cyclical stocks: Their profitability has a negative correlation with the movement of the economy. When the economy is expanding, share prices of counter-cyclical stocks fall; when the economy is contracting, share prices of cyclical stocks rise.

Alcohol-related businesses and discount retailers are typically considered counter-cyclical, in addition to payday lenders and outplacement agencies. Good or bad, these businesses see more demand from consumers for their goods and services during times of economic hardship.

How Do You Pick a Cyclical Stock?

Cyclical stocks are hard to select on a basis of market correlation because investors cannot accurately and regularly predict economic and market cycles. The coronavirus pandemic is an example of a black swan event, wherein an unpredictable change puts recessionary pressure on the economy. The pandemic ended the longest bull market in history, which originated in the recovery from the Great Recession of 2007 to 2009. The other factor to consider is that the market is forward-looking so the share prices of cyclical stocks will likely start to rise before the economy bottoms out and prices will start to weaken before the economy starts to turn down.

If you want to benefit from the upswings of cyclical stocks, the best way to do so is through a diversified portfolio that includes for instance, some non-cyclical and counter-cyclical stocks. Investing in all three types of “cyclical” stocks will cover some of your downside risk. When building an investment portfolio, it is common practice is to choose uncorrelated assets (bonds and stocks), as well.

The easiest way for an individual investor to purchase cyclical and non-cyclical stocks would be through an exchange-traded fund (ETF). The Fidelity MSCI Consumer Staples ETF (FSTA) is an example of a non-cyclical ETF; the Roundhill Sports Betting & iGaming ETF (BETZ) is an example of a consumer cyclical ETF. Remember to compare ETFs to their category peers when selecting one to invest in.

Conclusion

Cyclical stocks’ profitability is tied to the status of the economy: Share prices rise when the economy is expanding and fall when the economy is contracting. The market tries to anticipate changes in the economic fortunes of cyclical companies, so the share prices tend to move ahead of the actual economic upturns and downturns. This makes cyclical stocks potentially volatile, especially since economic and market disruptions are hard, if not impossible, to predict.

To hedge against investments in cyclical stocks, investors can select non-cyclical and counter-cyclical stocks to add to their portfolios. Non-cyclical stocks produce goods and services that consumers always need, so their share prices do not fall during economic contractions; however, they also do not rise as vertiginously as cyclical stocks do when the economy recovers and expands.

Counter-cyclical stocks are the total opposite of cyclical stocks: When the economy is contracting, share prices of counter-cyclical stocks rise.

If you want to invest in any of these types of stocks, it is good practice to build a diversified portfolio with a mixture of stock types.