Cyclical Stock

A cyclical stock is one whose price is influenced by systematic or macroeconomic shifts in the overall economy. Cyclical stocks are well known for tracking an economy's boom, peak, recession, and recovery phases. The majority of cyclical stocks belong to businesses that sell consumer discretionary goods, which consumers tend to spend more on during an expansion and less on during a downturn.

This comprehensive guide on cyclical stocks will explore what they are, their benefits, limitations, taxation, suitability, and lots more. We will also discuss the ideal time for investing in cyclical stocks and draw out the difference between cyclical and non-cyclical stocks.

So, whether you are a novice or a seasoned investor, this guide will provide informative insights into this variant of equity. Please keep reading until the end of the article and know how to make informed investment decisions.
Let’s dive in!
 

What is Cyclical Stock?

If you are wondering ‘what are cyclical stocks?’ We have the best answers for you.

Cyclical stocks are a typical equity variant closely tied to the business cycle. Consumer cyclical stocks are well associated with companies that seamlessly operate in sectors that are heavily influenced by economic conditions.
While economic activity expands and gains momentum, the demand for products and services of these companies automatically increases. Meanwhile, it drives the company's profits and revenues, helping it reach new heights.

Alternatively, the demand for similar goods and services automatically deteriorates during a recession. And this typically results in lower earnings for the best cyclical stocks.
 

How Cyclical Stocks Work?

Cyclical stocks tend to perform well during periods of economic expansion and underperform during recessions.

For instance, the demand for new electronic gadgets elevates during economic times. It’s because the potential customers have more disposable income at their bay. But when it comes to economic downturns, the demand automatically falls. And that is exactly when consumers are very likely to postpone big-ticket purchases.

As a result, the earnings of cyclical companies are significantly more volatile than those of non-cyclical companies because the latter is associated with industries that are less sensitive to economic cycles.

If you can predict economic cycles seamlessly, then you can earn substantial returns by investing in cyclical stocks. But as cyclical stocks are sensitive to economic cycles, they are a lot riskier than non-cyclical stocks. Therefore, it’s imperative for you to determine your risk tolerance before you consider investing in them.
 

Example of Cyclical Stocks

Here is a comprehensive listing of some of industry-based cyclical stocks examples:

●    Housing Industry: Lowe's, Home Depot, PulteGroup, etc.
●    Automotive Industry: Ford, General Motors, Tesla, etc.
●    Travel And Leisure Industry: Marriott International, Delta Airlines, Carnival Corporation, etc.
●    Retail Industry: Nordstrom, Macy's, Target, etc.
●    Industrial Manufacturing Industry: 3M, Caterpillar, General Electric, etc.

Please note that the revenues and profits of these companies are closely tied to the economic cycles. But cyclical stocks are extremely volatile and tend to carry higher risk because of their sensitivity to economic cycles.
 

Interdependence of Cyclical Stocks and the Business Cycle

Now that you are familiar with cyclical stocks meaning, you will definitely know that they’re closely tied to the business cycles.

However, the business cycle can be categorized into four typical stages: expansion, peak, contraction, and trough.
During the expansion stage, the economy is elevating, employment is at its peak, and the demand for goods and services is exceptionally sturdy. As consumers and businesses spend more and demand cyclical industries, it’s usually a good time for cyclical stocks. 

When the economy approaches its peak, demand for cyclical stocks automatically deteriorates. It’s mainly because the investors anticipate an economic downturn.

During the contraction stage, economic activity slows down, employment declines and demand for goods and services also decreases. This eventually leads to decreased revenues and earnings for cyclical stocks. And this is exactly when the cyclical stocks tend to underperform.

Finally, during the trough stage, the economy degrades and hits its lowest point before recovering again. This is an ideal time for investors like you to look into the potential opportunities in cyclical stocks. As the economy races to pick up, you might be undervalued and poised for growth.

In a nutshell, the performance of cyclical stocks is closely tied to economic activity. And those investors who are capable of predicting changes in the business cycle can earn significant returns by investing in these stocks.
 

Advantages of Cyclical Shares

Investing in cyclical shares comes with loads of benefits, such as the potential for higher returns during economic expansion. Here, we have listed some other advantages of investing in cyclical shares:

●    Value Opportunities
During economic downturns, cyclical shares can become undervalued. Thus, it can offer valued opportunities for those who can identify stocks with strong fundamentals and long-term growth potential.
●    Diversification
Investing in cyclical shares can provide diversification benefits to your portfolio. It does so by adding exposure to industries that aren’t correlated with other holdings.
●    Dividend Income
Several cyclical companies pay dividends that can provide a reliable source of income during bad and good economic times.
●    Inflation Protection
Certain cyclical sectors, like commodities, can provide inflation protection as their price rises with inflation.
●    Growth Potential
Cyclical shares provide strong growth potential as the economy expands. Furthermore, the demand for cyclical industries like construction and manufacturing also elevates.
 

Limitations of Cyclical Securities

Even though cyclical securities can provide potential advantages, there are certain limitations to the same. They are as follows:

●    Timing
Predicting changes in the business cycle accurately and timing investments in cyclical securities can be quite overwhelming. This can eventually lead to missed opportunities or losses for investors.
●    Risk
As cyclical securities are more volatile than non-cyclical securities, it can lead to leather swings in prices. Furthermore, it brings forth an increased risk for investors.
●    Competition
Competition in cyclical industries can be quite intense. And this can eventually lead to lower profit margins, price competition, and reduced earnings for companies.
●    Company-specific Risks
Cyclical companies are likely to encounter company-specific risks like technological advances or changing consumer preferences. This can deliberately affect their earnings along with stock prices.
 

Cyclical Vs. Non-Cyclical Stocks

Here is a table of differences between cyclical stocks and non-cyclical stocks:

Taxation on Cyclical Stocks

Taxation on cyclical stocks is quite similar to the taxation on all other stocks. Therefore, investors are typically subject to capital gains taxes when they sell their shares for a profit. Sometimes, they might also receive dividends that are subject to income taxes.

Nevertheless, the timing of purchasing and selling cyclical stocks may have an impact on the tax consequences. This is primarily because gains or losses realised within one year might be offset by gains or losses in another year. Please note that this condition will completely vary on your overall tax situation.
 

Suitability of Cyclical Stocks

Cyclical stocks are highly suitable for investors who are ready and willing to take more risks. It is also an ideal investment option for those who have a longer investment time horizon.

Even though these stocks deliver remarkable performance during economic expansion, it’s likely to become volatile during economic downturns. Therefore, as an investor, you must have the will to ride out the ups and downs of the business cycle.

These stocks are an excellent suit for investors who believe the economy to be poised for growth. Besides, they must also be keen to take advantage of the same for increased earnings and revenue for cyclical companies.

However, it is immensely crucial for you to be cautious and never consider over-allocating to cyclical stocks. Since their performance is quite unpredictable, they are subject to external factors beyond your control.
 

Different Cycles and Their Stocks

There are a plethora of cycles that affect different sectors of the stock market. Some of the most prominent ones include:

●    Sector Rotation Cycle
Here, different sectors lead or lag at different times.

●    Business Cycle
Energy, industrials, and materials perform quite well during expansionary phases.

●    Commodity Cycle
The demand and supply of commodities deliberately affect energy and material stocks.

●    Interest Rate Cycle
Financials and consumer discretionary stocks are quite sensitive to the changes in interest rates.

●    Technological Cycle
Advancements in technology can drive growth in tech-related stocks like those in the semiconductor industry.
When you clearly understand these cycles and their corresponding sectors, you can seamlessly make informed investment decisions.
 

When to Invest in Cyclical Shares?

When it comes to investing in cyclical shares, things can be quite challenging. It’s because their performance is typically tied to the business cycle.

However, there are certain things you should consider while determining whether or not you should be investing in these stocks. Here, we have listed a few of them:

●    Industry-Specific Factors
Different sectors might experience cyclical patterns at different stages. For instance, when the housing market experiences a boom-and-bust cycle, the technology sector may experience cycles of innovation and obsolescence. Thus, you should conduct thorough research on your desirable industries and determine the timing of cyclical patterns.

●    Economic Indicators
As an investor, you should keep an eye on the key economic indicators. Some of them include employment rates, GDP, consumer spending, etc. This helps in identifying the most prominent phases of the business cycle. As cyclical stocks perform well during an economic expansion, investing during such phases is an ideal choice.

●    Diversification
To manage risk, you must diversify your portfolio. Therefore, investing in a mix of cyclical and defensive stocks, bonds, and other asset classes can help you smoothen your portfolio’s volatility.

●    Valuation
With regard to any investment, valuation is quite important. As a potential investor, you should look out for undervalued cyclical stocks. You can also consider trading at a discount relative to your earnings or book value. This offers you a margin of safety if the business cycle turns negative.

You will probably know that cyclical stocks require careful analysis and understanding of the involved risks. If you are willing to ride out the ups and downs of the business cycle, you must consider the advice of a financial professional.
 

Conclusion

Cyclical stocks provide a plethora of opportunities for investors to benefit from economic growth and expansion. However, they come with potential risks like other stocks.

Thus, as a responsible investor, you should have a long-term view and have the willingness to tolerate utility. Besides, you must also diversify your portfolio to mitigate risks. When you clearly understand the different cycles and their corresponding sectors, you can make informed investment decisions.