Stock Market Guide: What are cyclical stocks?

The financial market is known for its uncertainty and volatility. Any investor or shareholder that is active in the stock market for some time knows that it is affected by a number of factors, both expected and unexpected.

Uncertainties and volatility are common to any company but cyclical companies suffer most from outside factors. Cyclical stocks keep pace with the ups and downs of the economy, just as commodity stocks are sensitive to the prices of the products they sell. Even mature and stabilized companies in the business suffer from cash flow volatility in their operations.

The price of cyclical stocks is affected by systematic changes in the economy. They are known for following the cycles of expansion, peak, recession and recovery. Non-cyclical stocks, on the other hand, beat the market regardless of the economic trend.

Non-cyclic vs. cyclical stocks

Cyclical stocks are highly correlated with business cycle movements, while a non-cyclic stock has little or nothing to do with movements that correlate with the business cycle.

Cyclical stocks include companies operating in industries with high consumer spending during economic expansion. Companies in the auto, construction and luxury item industry are some examples of cyclical stocks.

Also known as defensive stocks

Non-cyclical stocks, also known as defensive stocks, include companies that operate in industries that function well during economic downturns. This happens because such companies sell essential goods. Luxury goods are nice, but people need water, electricity, gas, and medication.

Companies with non-cyclical inventories have continuous demand, meaning that the demand for their product or services is always there. Companies with cyclical stocks, on the other hand, have a demand for products that fluctuate based on the economic environment. 

When times are rough

During an economic downturn, people will probably buy medicine if they are sick but will have second thoughts before buying a new car or traveling abroad. Through tough economic times, cyclical companies will be the first to experience the impact. Since they don’t offer non-essential services or goods, there will be a considerable reduction in their profit. As both consumers and governments begin to reduce expenses, companies can even suffer losses, causing their shares to depreciate.

Keep a close watch on the relationship between supply and demand

Cyclical stocks comprise businesses that have cyclical supply and demand numbers. At some point in the year, demand increases but supply does not keep up with this movement. Consequently, the offered product becomes more expensive, which has a positive impact on the stock price. So, the investor’s objective is usually to buy the papers during the high price period of the product and sell when that value retreats.

The purchase of shares of these companies at the beginning of the high price cycle and their sale at the beginning of the low price cycle is crucial to the profitability of the operation.

Detecting signs

However, it can be difficult to anticipate those cycles. Big investors must be able to detect the first signs of improvement or deterioration to identify when to invest high or low.

But if you are an average investor or a buy and hold investor, you don’t need to worry so much about stock price fluctuations. You can still focus on buying stocks from good companies, cyclical or not, at favourable prices.   

The importance of understanding companies and their sectors

You can not only look internally at a company and say that you know it deeply. An external analysis is also needed to identify how sensitive the industry is to economic variables.

Cyclical stocks fluctuate sharply as those companies lose billions in recession and earn billions in periods of prosperity.

If you are new to investing and want to buy stocks as long-term fundamental investments, then you want to invest based on the underlying business of the company. While cyclical stock gains can fluctuate, many long-term investors still keep carmakers or construction stocks in their portfolios.

If you see a slowdown ahead, emphasize defensive stocks

Non-cyclical or defensive stocks, such as food, beverages, utilities and medical stocks, whose profits are sustained in bad times, do not always reflect this in their stock prices, but their prices generally do not fall as much. For example, if the Dow Jones industrial average falls by 10% to 15%, perhaps cyclical stocks will fall by 25% and the non-cyclical ones will fall only 5%.

Investing in cyclical stocks requires patience

Economic cycles last for years, even decades. Recessions and other forms of economic downturns may continue for years before a recovery begins. Therefore, while the timing of the market is always difficult, the long duration of these cycles makes it even more difficult. So, when buying cyclical stocks you should be willing to keep them for the long term, if necessary.  

Conclusion

Cyclical sectors can be very interesting investments in times of economic growth, where corporate revenues and profits are skyrocketing and this positive result is generally reflected in high valuation of securities. However, investing in these sectors at the wrong time in the cycle can compromise much of the capital invested. Knowledge and caution are required when it comes to investing in cyclical companies.

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