Investing in the stock market can be an exciting way to grow your wealth, but it's crucial to understand the different types of stocks and how they behave. One category worth exploring is cyclical stocks, which are influenced by the ups and downs of the business cycle. Over long periods of time, most investors expect to receive higher growth from cyclical stocks than defensive stocks.
In this article, we will define cyclical stocks, explain how macroeconomic factors impact their prices, provide examples of cyclical stocks, discuss their volatility compared to defensive stocks, highlight typical cyclical industries, and outline the advantages of investing in cyclical stocks.
What are Cyclical Stocks?
Cyclical stocks are shares of companies that tend to perform well when the economy is booming but may struggle during economic downturns. They are closely tied to the business cycle, which refers to the recurring patterns of economic expansion and contraction. Cyclical stocks are known for their sensitivity to changes in consumer spending and economic conditions.
The Impact of Macroeconomics on Cyclical Stocks:
Macroeconomics is the study of the overall economy, including factors like employment rates, inflation, interest rates, and gross domestic product (GDP). These macroeconomic factors play a significant role in determining the prices of cyclical stocks.
When the economy is strong and people have more money to spend, cyclical stocks tend to thrive. For instance, during an economic expansion, consumers are more likely to purchase new cars, travel, and invest in home improvements. This benefits companies operating in industries such as automotive, airlines, and construction.
On the other hand, during economic downturns, people tend to tighten their budgets, leading to reduced spending on non-essential goods and services. This can negatively impact cyclical stocks, causing their prices to decline. Understanding how macroeconomic factors influence the business cycle helps investors react to market trends.
Examples of Cyclical Stocks:
1. Ford Motor Company: Ford is a prime example of a cyclical stock. As an automaker, the company's performance is closely tied to economic conditions. During economic expansions, people have more confidence and disposable income, which drives increased car purchases. However, during economic downturns, consumer spending on big-ticket items like cars tends to decline, affecting Ford's profitability.
2. Delta Air Lines: Airlines, including Delta Air Lines, are also cyclical stocks. When the economy is strong, people have more discretionary income to spend on travel, leading to increased airfare bookings. However, during economic downturns or times of high fuel prices, consumers may reduce travel, impacting the airline industry and Delta's stock performance.
3. Home Depot: Home Depot, a home improvement retailer, is another example of a cyclical stock. During economic expansions, homeowners are more likely to invest in renovations and repairs, benefiting companies like Home Depot. Conversely, during economic downturns, people may delay or scale back home improvement projects, affecting the demand for Home Depot's products and services.
Volatility of Cyclical Stocks:
Cyclical stocks are generally more volatile than defensive stocks. Volatility refers to the degree of fluctuation in a stock's price over time. Cyclical stocks tend to experience wider price swings due to their sensitivity to economic conditions.
For instance, during economic downturns, investors may become more risk-averse and shift their investments towards defensive stocks. Defensive stocks, such as utilities or consumer staples, are less influenced by economic cycles as they provide essential goods and services that people continue to use even during challenging economic times. In contrast, cyclical stocks can experience substantial price declines during economic downturns, as consumer spending and investor confidence wane.
Typical Cyclical Industries:
Several industries are considered cyclical due to their close ties to economic fluctuations. These include automotive, airlines, construction, retail, manufacturing, and travel and tourism. The performance of companies within these industries often mirrors the overall health of the economy. When economic conditions improve, these industries experience increased demand, leading to higher profits and stock prices.
Sometimes people call Cyclical Stocks “Consumer Discretionary” Stocks. They use the word discretionary because customers may choose not to spend money at these businesses when the economy isn’t as strong.
Sometimes people call Defensive Stocks “Consumer Staples”. They are staples because consumers are unlikely to stop spending even in difficult financial situations.
Here is a list of 15 stocks inside the Consumer Discretionary fund XLY. Notice the industry of each stock. It makes sense that customers might reduce their spending in these industries when their finances are tighter.
Here is a list of 15 stocks inside the Consumer Staples fund XLP. The industries could be considered boring. That is typical of staples. Consumers are more likely to keep spending on these items during downturns in markets and the economy.
Advantages of Investing in Cyclical Stocks:
Investing in cyclical stocks offers several advantages:
1. Potential for higher returns: During economic expansions, cyclical stocks have the potential to generate significant returns. As the economy strengthens and consumer spending increases, these stocks may experience substantial growth.
2. Capitalizing on economic recovery: By investing in cyclical stocks, investors can position themselves to benefit from the recovery phase of the business cycle. When the economy starts to rebound after a downturn, cyclical stocks are often among the first to rally, presenting opportunities for capital appreciation.
3. Diversification: Including cyclical stocks in your investment portfolio can help diversify risk. Cyclical stocks tend to perform differently from defensive stocks, allowing investors to spread their investments across various sectors and mitigate the impact of any one industry's performance.
Here are some charts showing cyclical stocks, defensive stocks, and the S&P 500 against each other. Notice that during 2023, cyclical stocks have done very well.
During a down year like 2022, defensive stocks have outperformed.
Over long periods of time as in the last chart, you will notice that cyclical stocks have done better than defensive ones. This is a classic example of being paid more for taking more risk. The additional risk isn’t for everyone, but most portfolios should be diversified which means they should have some exposure to cyclical stocks to keep up with inflation.
To sum it up:
Cyclical stocks are shares of companies that are closely tied to the business cycle and influenced by macroeconomic factors. Understanding their behavior and the industries they represent can help investors make informed decisions. While cyclical stocks come with higher volatility, they also offer the potential for significant returns, especially during economic expansions. By carefully analyzing the macroeconomic environment and diversifying investments, investors can capitalize on the opportunities presented by cyclical stocks.
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