Cyclical Stocks Explained
Cyclical stocks are shares in companies whose performance tends to rise and fall in line with the wider economy. When growth is strong and consumer confidence is high, these stocks often flourish. However, when the economy contracts, they typically feel the pressure first.
Understanding how cyclical stocks behave and how they differ from their defensive counterparts can help investors make informed decisions about portfolio construction. Below, we explain what cyclical stocks are, explore the sectors and companies that fall into this category and look at the different ways investors can gain exposure to them.
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
Table of Contents
- Cyclical Stocks Definition
- How the Economic Cycle Affects Cyclical Stocks
- How to Identify Cyclical Stocks
- Cyclical Stocks vs Defensive Stocks
- Cyclical Sectors and Industries
- Examples of Cyclical Stocks
- Pros and Cons of Cyclical Stocks
- How to Invest in Cyclical Stocks
- Conclusion
- Frequently Asked Questions
Cyclical Stocks Definition
A cyclical stock is a company whose revenues and profits are closely tied to the health of the wider economy. As economic conditions improve and consumer spending rises, these companies tend to generate stronger earnings, with share prices typically reflecting that. When the economy slows or enters a recession, the opposite usually occurs.
The defining characteristic of most cyclical stocks is that they operate in industries producing goods or services that people want rather than need. These are referred to as consumer discretionary goods - things such as cars or holidays. When household budgets come under pressure, these expenditures are most likely to be cut back.
This sensitivity to the economic cycle is what differentiates cyclical stocks from defensive stocks. Defensive stocks tend to be more resilient during downturns because they produce goods and services which people typically buy regardless of economic conditions.
How the Economic Cycle Affects Cyclical Stocks
To understand cyclical stocks, it helps to understand the economic cycle that characterises economies over time. This cycle is typically defined by four stages:
It’s worth noting that markets are forward-looking. For example, by the time a recession is formally declared, cyclical stocks may have already fallen significantly. Similarly, the early stages of a recovery can see these stocks rebound sharply before economic data confirms the turn.
How to Identify Cyclical Stocks
Not every cyclical business may be immediately obvious, here are some of the key signals:
- Sector: Cyclical stocks typically operate in specific industries - including consumer discretionary, financials, industrials, mining and energy.
- Revenue patterns: Cyclical companies’ revenues tend to rise and fall in tandem with economic growth
- Beta: A measure of how much a stock's price moves relative to the broader market, with a beta of 1 meaning a stock moves in line with the wider market. Many cyclical stocks carry a beta above 1, implying they are more volatile than the wider market.
- Demand elasticity: Are the company's goods or services the kind that consumers cut back on when money is tight?
Cyclical Stocks vs Defensive Stocks
Cyclical stocks are perhaps best understood alongside their counterpart: defensive stocks.
Whilst cyclical stocks are sensitive to the economic cycle, defensive stocks tend to perform relatively consistently regardless of economic conditions.
That’s because defensive stocks operate in industries that produce goods and services in constant demand - such as food, utilities and healthcare. Whilst consumers may tighten their budgets during a downturn, they don’t tend to stop buying groceries or paying energy bills. By contrast, cyclical stocks depend on consumers having sufficient disposable income to spend on non-essential goods and services.
Cyclical Sectors and Industries
Cyclical stocks are found across a range of sectors, but they tend to concentrate in industries where consumer and business spending is most sensitive to economic conditions. The main cyclical sectors include:
- Consumer discretionary
- Financials
- Mining
- Energy
Consumer Discretionary
Consumer discretionary is the broadest and most recognisable cyclical sector. It covers companies selling non-essential goods and services – such as automakers, hotels, airlines and restaurants. Spending in this sector tends to expand when consumer confidence is high and contract sharply when household budgets come under pressure.
Financials
Banks and asset managers are closely tied to the economic cycle. During periods of growth, lending increases and financial markets tend to perform well, which benefits financial stocks. In a downturn, the opposite tends to be true.
Mining
Mining companies and raw materials suppliers are very sensitive to global economic activity. Demand for commodities rises during periods of expansion - driven by construction and infrastructure investment - and falls when activity slows.
Energy
Oil and gas producers are cyclical because energy demand tends to rise and fall along with economic activity. The sector is also heavily influenced by commodity prices, which introduces an additionallayer of volatility beyond the economic cycle itself.
Examples of Cyclical Stocks
The following table highlights a selection of well-known cyclical stocks across different sectors. These are illustrative examples chosen to show the range of industries and business models that fall into the cyclical category.
Pros and Cons of Cyclical Stocks
Like any investment, cyclical stocks carry a distinct set of potential benefits and drawbacks.
Pros
- Growth potential during expansions: Cyclical stocks can deliver strong returns during periods of economic growth.
- Economies spend more time expanding than contracting: Historically, periods of economic expansion have tended to last longer than recessions.
- Wide range of sectors and companies: Cyclical stocks span multiple industries, giving investors plenty of options.
Cons
- High volatility: Cyclical stocks can fall sharply and quickly when economic sentiment turns.
- Recession vulnerability: In a severe or prolonged downturn, some cyclical companies may face significant financial pressure.
- Timing is difficult: Identifying the right points to enter and exit cyclical stocks requires a view on where the economy is heading, which is notoriously difficult to predict.
How to Invest in Cyclical Stocks
The following steps outline a practical framework for how to approach investing in cyclical stocks.
1. Identify Sectors and Companies
Start by identifying which cyclical sectors align with your interests and risk appetite. From there, you can research individual companies within those sectors.
It’s worth analysing a company’s financial resilience and, if possible, how it has held up during previous downturns. A company with a strong balance sheet will be better placed to weather a period of economic decline than one with no cash and lots of debt.
2. Consider the Broader Economic Context
Whilst economic conditions don't need to dictate when you invest, they may be worth factoring into your thinking. A cyclical stock purchased during a period of economic uncertainty may offer a different return profile to one bought at the peak of an expansion. However, it’s important to remember that predicting turning points is difficult and attempting to time the market carries its own risks.
3. Choose How to Gain Exposure
There are a couple of ways to gain exposure to cyclical stocks:
- Share ownership: Buying shares in individual companies using an investment account provides targeted exposure but requires thorough research and carries higher concentration risk.
- ETFs: Exchange-traded funds focused on consumer discretionary, mining, energy or other cyclical sectors provide diversified exposure through a single investment.
4. Manage position sizing carefully
Given the volatility of cyclical stocks, it’s important to consider how much to allocate to them within your portfolio. Larger positions in highly cyclical names can expose a portfolio to sharp drawdowns during economic downturns or periods of uncertainty.
Conclusion
Cyclical stocks are businesses whose fortunes are closely tied to the health of the economy, such as financial institutions and consumer discretionary companies.
For investors, the appeal of cyclical shares can lie in their potential to deliver strong returns during an economic expansion. However, the trade-off is greater vulnerability when conditions deteriorate. Understanding how cyclical stocks work and how they fit alongside other types of investments is useful for those looking to build a diversified portfolio.
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Frequently Asked Questions
What sectors are considered cyclical?
The main cyclical sectors include consumer discretionary, financials, mining and energy.
What is the difference between cyclical and non-cyclical stocks?
Cyclical stocks typically rise and fall with the economy, whilst non-cyclical stocks - often referred to as defensive stocks - tend to remain relatively stable regardless of economic conditions.
Are banks cyclical stocks?
Yes. Banks and other financial institutions are considered cyclical because their revenues are sensitive to economic conditions. Lending volumes and trading revenues tend to rise during periods of economic growth and contract during downturns. Loan defaults also increase during recessions, putting additional pressure on profitability.
Is technology a cyclical sector?
It depends on the type of technology company. Businesses selling consumer electronics and other discretionary technology tend to behave cyclically. However, large enterprise software and cloud infrastructure providers can generate recurring revenues that make them more resilient throughout the economic cycle.
How do cyclical stocks perform during a recession?
Cyclical stocks typically underperform during recessions, as falling consumer confidence and reduced spending directly impact the revenues of these businesses. The extent of the impact varies; companies with stronger balance sheets and lower debt levels tend to be more resilient than those with low amounts of cash and lots of debt.
Can cyclical stocks pay dividends?
Yes, many cyclical companies do pay dividends. However, dividends from cyclical stocks may be less consistent than those from defensive companies. During a downturn, payouts can be reduced or suspended as businesses look to preserve cash. Investors seeking reliable income may find cyclical stocks less suited to that purpose.
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