Cyclical stocks are assets in the securities markets whose rises, peaks, falls, and recoveries tend to mirror the performance of the general economy. Their performances are closely intertwined with consumer behavior under different economic performance cycles.
Therefore, investing in such securities means that your returns will be dependent on the cyclical peaks and declines in the uptake of non-essential goods and services. The shares of hotels, luxury goods companies, vehicles, and airlines are good examples.
How can you identify cyclical stocks?
In the securities exchange markets, you can identify cyclical stocks based on their relatively high beta value. The beta value tells us the correlation between the stock’s performance and the performance of the rest of the securities market. The beta value of such stock is typically more than 1. For example, a stock whose beta value is 1.2 will rise by 12% if the stock market rises by 10% and vice versa.
The second key indicator of cyclical stocks is the price to earnings (PE) ratio, which is usually low in companies with cyclical stocks. Thirdly, they have earnings per share (EPS), which tend to have wide fluctuations due to the relatively high differences in earnings during different economic cycles.
Stages of cyclical stocks
Growth phase: This phase involves steady gains by the company, with the expansion of production capacity, opening up of new branches, additional manufacturing plants, high rate of recruitment of staff, etc. These result in a multiplier effect, with the company’s presence in the economy steadily established and its stock rising to reflect the company’s rising returns.
Peaking phase: At this point, the company’s capacity is at an optimal level, with the ability to surpass the market demand. This results in diminished profit margins as the market becomes saturated.
Decline phase: After the peak period, the company finds itself in a situation where there is little room for growth. This results in the company being unable to generate profits, with loss-making setting in. This is reflected in the stock market in the form of declining stock prices. Companies with a weaker capital base may end up shutting down operations.
Recovery phase: When some of their competitors have gone out of business during the decline phase, the remaining companies take advantage of the market to return to profitability. The remaining companies can’t expand their market share, which is reflected in the form of a spike in the stock price.
Why should you trade in cyclical stocks?
Profiting from volatility
The strong price fluctuations in these stocks provide investors with excellent opportunities to profit from the large swings in either direction. During upswings, investors gain from the high rise in stock value. Similarly, investors can sell their stock at a profit through proper timing of the decline phase of the cyclical stock.
Finding rough diamonds
Cyclical stocks are often linked to companies that are undervalued, especially when the companies’ core line of business is deemed to be “out of season.” If you have a good understanding of valuation, you can spot opportunities to invest in them when they are undervalued and make profits when they appreciate.
Opportunities to diversify
Because of the periodic rises and falls in economic performance, cyclical stocks offer great opportunities to diversify investment portfolios. Specifically, it is advisable to have a good balance between cyclical and non-cyclical stocks.
When should you invest in cyclical stocks?
- When there is an imminent economic stimulus: In recent times, governments have had to intervene during periods of economic inactivity as a way to catalyze economic productivity. Examples include the economic recession of 2007-2008 and the post-Covid-19 era.
Economic stimulus packages increase the circulation of money in the economy. This presents investors with great opportunities to invest in cyclical stocks. Cyclical stocks draw their momentum from the increased consumer spending that comes with stimulus money. After a period of reduced economic output, stimulus checks trigger increased production and consumption.
- When there is a spike in the economic productivity in a country: Economies have cycles of steady growth, which are characterized by a spike in consumer spending and growth in corporate expansion. Those who correctly identify the times have a great opportunity to lock in profits during these times.
Advantages of Cyclical Stocks
- Fast growth rates – Cyclical stocks mimic the performance of the economy. Therefore, investors reap proportionately high returns when the economy is on the ascent.
- They rise when interest rates fall – When interest rates fall, people have greater access to funding. This results in increased expenditure by consumers and business enterprises, leading to gains by cyclical stocks. Therefore, investors often take advantage of falling interest rates to profit.
- They are more receptive to the economy than the benchmark indices – cyclical stocks have a higher beta value, which makes them more volatile than their corresponding benchmarks. This gives investors in cyclical stocks better returns than the average market performance.
Disadvantages of cyclical stocks
- They easily lose value during reduced economic output – Cyclicals are based on their innate close relationship with the economy. These stocks are susceptible to economic recessions. During such times, consumer expenditure reduces significantly, leading to a decline in the value of a stock.
- Poor timing may result in losses – At times, investing in cyclical stocks may come at a time when the economy is about to slow down. This may put investors in a situation whereby they buy a stock at a peak price, only for the value to plummet shortly afterward. This may force some investors to sell their stock at a loss.
- Volatility brings uncertainty – These stocks appreciate during an economic boom, but the gains made can easily be reversed when they begin to depreciate during periods of reduced economic output. Notably, their high beta values may result in losses beyond the average market losses.
- May require detailed expert analysis of the market – Due to their volatile nature, these cyclicals require a detailed understanding of the performance of different stocks. In addition, you need to be alert for rapidly changing fundamentals and technical indicators. These may be tiring and time-consuming.
Cyclical stocks are worthwhile assets to invest in, and they offer a good opportunity to diversify a portfolio. They are closely linked to the performance of the greater economy. However, they require close monitoring and appropriate adjustments from investors as the economic performance fluctuates.