What is a Cyclical Stock?

Cyclical stocks are like outdoor sporting events…

Some sports such as baseball rely on good weather to occur. When the weather is good, the game can go on. But if it rains, they may have to call off the game. Similarly, the fate of cyclical stocks relies heavily on the overall economy. They do well when the economy does well. Non-cyclical stocks, those not dependent on the state of the economy, are like playing baseball in a domed stadium - the game goes shielded from the weather.

A cyclical stock is one whose returns are in tune with the state of the economy. When the economy does well, these stocks tend to perform especially well. But in times of economic downturn, these stock prices are likely to suffer.

Because these stocks are heavily affected by the state of the economy, the portfolios of investors who have their money in these stocks are heavily affected as well. If an investor were to invest primarily in cyclical stocks, their returns might look good when the economy is thriving, but they might suffer declines when the economy turns downward.

When the economy does poorly, people often spend less money. In some cases, people lose their jobs and are forced to cut back on spending. Others might still have their jobs but reduce their spending out of caution, wanting to hold onto their money in case they need it later.

When people have less money to spend, they stop spending money on discretionary items - goods like cars and travel that they don’t have to buy (as opposed to items like food or housing or utilities that they need to survive). As a result, the companies that sell those discretionary items see their businesses and their stock prices suffer.

It works the other way, too. When the economy is doing well and more people have jobs, people are more likely to spend more money. They’re more likely to take a vacation, buy a new house, or go out to eat. As a result, companies in those sectors see an increase in revenue, and usually an increase in their stock prices as well.

There are different ways of dividing stocks into sectors, but financial information company Morningstar does so by how sensitive they are to the ups and downs of the economy, and it identifies four primary sectors that are considered to be cyclical stocks: Basic materials, consumer cyclical, financial services, and real estate.

• Basic materials companies manufacture paper products, building materials, and chemicals. This sector produces materials used in construction, which increases and decreases along with how the economy is doing.
• Consumer cyclical companies are auto makers, appliance makers, airlines, travel companies, restaurants - any company whose goods consumers might buy more of when the economy is good but cut back on buying when the economy is bad. (Other consumer goods like food and household products are considered non-cyclical, or defensive, because consumers will buy them no matter what the economy is like.)
• Financial services companies are banks, insurance companies, brokerage firms, and credit services. Their products and services are more in demand when the economy is strong: People invest more and borrow more to buy homes and cars.
• Real estate includes companies such as mortgage firms and real estate investment trusts (REITs), which are companies that own investment properties. Real estate is more in demand when the economy is strong, and less in demand when it isn’t.

Cyclical stocks are those whose returns tend to rise and fall with the economy, because the companies make discretionary goods that people tend to stop buying during an economic downturn. Examples include:

• Travel: People tend to travel less for vacations and business during recessions. As a result, airlines and other travel companies typically lose profit and see their stocks go down.
• Luxury goods: Companies selling luxury goods like jewelry and high-end fashion tend to lose sales during economic downturns. The 2008-09 recession lopped 9% off the value of the luxury-goods market, according to consulting firm Bain & Co., though it bounced back relatively quickly.
• Housing: People are less likely to buy homes or pay for home renovations during an economic downturn or recession. So when the economy goes down, so do the stock returns for real estate corporations.
• Automobiles: People are also less likely to buy a new car during a recession. Some can’t afford it; others might choose to be cautious and put the money they’d intended to use for a car away in their emergency fund. As a result, car companies tend to see their stocks suffer when the economy turns downward.

Cyclical stocks are those whose returns tend to rise and fall along with the health of the economy. That’s because these companies provide products and services that people buy more of when the economy is doing well, and buy less of or stop buying altogether when the economy is doing poorly.

Non-cyclical stocks, also known as defensive stocks, are far less dependent on how the economy is doing. Companies with defensive stocks provide products that people need even when the economy is doing poorly. For example, most families will still buy food and pay the electric bill, even when times are tough. They’ll still spend money on healthcare and prescriptions. As a result, these stocks tend to be more resilient than cyclical stocks.

One might assume that financial services companies would be considered non-cyclical or defensive. People still need checking and savings accounts during recessions, right?

But banks’ health varies with how much borrowing people do. Real estate and automobiles are cyclical industries - and when people buy homes or cars, they head to their bank to take out a loan. The bank makes money from the interest the borrower pays. When a recession hits, people stop buying houses and cars, they borrow less money, and so banks earn less interest.

Other financial companies like brokerage firms and wealth management firms are cyclical because investing can fluctuate depending on the health of the economy. When the economy is doing poorly, investors may be hesitant to put money into the stock market, so financial services firms might make less money.

Because cyclical stock prices rise and fall with the economy, and their returns may suffer during economic downturns, investors might be hesitant to invest in these companies. But there are also times when cyclical investing is especially profitable. After a recession when the economy is recovering, prices of cyclical stocks tend to bounce back quickly, often outperforming defensive stocks.

However, there’s no way to know for sure when the economy is about to take a turn. Buy and hold investors may want to keep cyclical stocks as a regular part of their portfolios in the hopes that the higher returns during good economic times offset the lower returns during downturns.

Companies like Morningstar publish lists of cyclical stocks with information about their industry, current price, and market return.

An exchange-traded fund (ETF) is a financial instrument that tracks the performance of collections of securities usually associated with an index. ETFs allow investors to invest in a sector or industry without buying individual securities. Some mutual-fund families and ETF providers offer ETFs that specifically track cyclical stocks. Investors can invest in cyclical stock ETFs through their brokerage account or a financial advisor.