Interested in cyclical stocks? Find out how the economy affects their performance, their advantages and disadvantages, and how you can start investing in them.
Cyclical stocks are similar to economies in the way they experience growth and recession cycles: when the economy is booming, cyclical stocks rise, and when the economy slows down, they follow. The volatility of the sharp and fast price fluctuations that these stocks experience tends to generate large amounts of news coverage.
Regardless of whether you have heard the term before, you are likely to be familiar with some of the companies considered to have cyclical stock, such as Tesla and Netflix.
Whether you want to mix up your risk appetite or see an opportunity in market conditions, there are a range of reasons you might be interested in cyclical stocks. Read on to learn about investing in cyclical stocks and discover how you can find the best ones for you.
What are cyclical stocks?
Cyclical stocks are stocks whose prices move in tandem with the economy. Ranging from macroeconomic factors, systematic changes in the economy or global events such as conflict or a pandemic, cyclical stocks will fluctuate alongside the conditions of their region.
Examples of cyclical stocks are those issued by consumer discretionary companies, meaning those companies that offer non-essential consumer goods, such as Amazon, Starbucks and Nike. Consumer discretionary stocks are considered a sub-group of cyclical stocks.
As cyclical stocks follow the overall trends of the economy, they are considered highly volatile.
Cyclical stocks vs. defensive stocks
A great way to distinguish cyclical stocks from non-cyclical stocks is to consider whether they are a product or service you need or something you want:
- Needs: groceries, utilities, medicine, rent
- Wants: fashion, travel, eating out, entertainment.
Populations will always need consumer staples, such as food, water and power, so these industries and stocks are non-cyclical (or “defensive”). However, individuals can survive without the latest fashions, holiday travel and eating out, which makes the relevant industries and stocks cyclical.
How to find high-quality cyclical stocks
When searching for cyclical stocks in which to invest, investors should consider the industries that typically rise and fall through economic cycles, those most vulnerable to changes in consumer spending or those that are dependent on customers having disposable income.
These industries may include food delivery services, entertainment such as streaming services, or luxury retail like cosmetics and fashion. Automotive, construction and certain elements of the technology industries are considered cyclical, too, as they are highly sensitive to market sentiment and faith in innovation.
Investors can seek to choose stocks in accordance with various stages throughout the economic cycle, as these stages are closely tied to market conditions. During a period of economic expansion, for example, the demand for luxury goods and services is likely to increase. When the economy contracts, this demand is likely to decrease.
Investors who want to invest in cyclical stocks should be aware of the risks and benefits of this approach.
What are the pros and cons of cyclical stocks?
As with all investing strategies, there are positives and negatives to investing in cyclical stocks.
- Potential for high returns during industry booms.
- There are more expansion than contraction periods in the economy.
- Easy stocks to identify, e.g., luxury brands, cars, airlines and hotels.
- Possible to diversify investments across sectors to reduce risk.
- Cyclical stock prices can be highly volatile.
- May not survive recessions.
- Timing the market cycles for entry/exit points is difficult even for experts.
- Potential to lose substantial amounts of capital buying at the wrong stage of a cycle.
How to invest in cyclical stocks
There are various strategies available for investors to assess, and invest in, cyclical stocks. Here are four key considerations:
Time your position
Cyclical stocks rise and fall in line with the economy, so, ideally, investors should try to buy them at the market bottom and sell at the top, which can be difficult to pull off.
Generally, cyclical stocks are a popular short-term trading strategy rather than a long-term, “buy-and-hold” strategy.
Fundamental Analysis
Investors can identify the leaders in market sectors by using fundamental analysis, and prepare to buy them as the market cycle transitions into expansion. Fundamental analysis is a technique that helps investors to understand an asset’s “real-world” or fair market price, often by using indicators such as market sentiment or company reports.
Various fundamental indicators exist to measure a company’s value, such as price-to-book ratio (this compares a company’s market value to their book value), which is considered a better indicator than price-to-earnings ratios.
Tip: Investors should also seek strong balance sheets, as cash is king when it comes to surviving recessions.
Technical analysis
Some investors like to use technical analysis to identify opportunities to enter or exit the market. This practice centres around using historical data from chart patterns to predict future price trends, and technical indicators can help investors to identify overbought or oversold market conditions.
Scale your entries
Don’t invest everything at once. Investors can hedge heir investments by staging a progressive series of buy-ins, at various points over time, to better average their market buy-in position. Investors can also use a stock’s price movement over time to confirm their view of the stock’s behaviour and identify any patterns that might present opportunities.
Summary
Cyclical stocks tend to be those of companies that provide discretionary or non-essential products, rather than those essential to survival. Cyclical stocks move in line with the wider economy. When the economy is booming, this type of investment tends to perform well, but in times of recession, can pose high risk to investors. For this reason, cyclical stocks should always be balanced with non-cyclical stocks in a diversified portfolio.
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FAQs
- Should you buy cyclical stocks?
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As with all types of stocks on the market, investing in cyclical stocks is a personal decision. Be sure to weigh up the advantages and disadvantages of these stocks, assess your risk tolerance and consider your investment goals before making any investment decisions.
- Are airlines cyclical stocks?
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Yes, airline stocks are cyclical. During periods of economic uncertainty, consumers may limit travel for business and leisure.
- What are examples of non-cyclical stocks?
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While cyclical stocks are generally affected by the state of the economy, non-cyclical or defensive stocks are less likely to be impacted to the same extent. Examples of non-cyclical stocks include those operating in the food, utilities, healthcare and pharmaceutical industries.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.