“Different strokes for different folks”
This English proverb says it all: people are different and they prefer different things. So do investors. Some like to invest in cryptocurrency while others enjoy putting their money in stocks.
Nevertheless, there is one thing that they all have in common – economic knowledge.
Being an investor requires a specific set of skills, but if you don’t understand the basics of the global economy and how the market works, it will be difficult to make the right decisions.
Having said that, each economy has cycles – periods of expansion and contraction. This is also called a business cycle. And even though we have no control over the market, we can adjust ourselves and our decisions to the ever-changing conditions. It’s essential to know that depending on this business cycle, we have two types of companies. Those whose stocks are closely related to changes in the business cycle are called cyclical.
On the other hands, we call companies that are more resilient to fluctuations non-cyclical. This article will be looking at those two main types in more detail. Let’s begin the journey.
Cyclical Vs Non-Cyclical Stocks
Before we start discussing the topic in more detail, let’s define both cyclical and non-cyclical stocks.
A cyclical stock is more likely to move in the direction the market moves. If the economy is increasing, the stocks perform well. In contrast, when the market goes down so does the price of the stocks. Companies whose stocks are cyclical tend to be more prone to various economic fluctuations. Due to their correlation to the economic movements, investors usually buy large amounts of them when the cycle is down and sell heavily when it’s up. This is a good strategy to benefit the most from the business cycle.
Non-cyclical stocks (also known as defensive stocks) belong to companies which the market doesn’t affect as much as the other type. Or, simply said, non-cyclical stocks are more immune to market fluctuations. For instance, utilities, food producers, pharmaceuticals are pretty immune to recessions or expansions. This is quite logical since people always need food, medicine, electricity regardless of the economic situation.
How Cyclical Stocks Work
In the previous section, I outlined the main factors that affect cyclical and non-cyclical stocks. Let’s go into more detail on how they actually work.
When the economy is expanding, people’s spending increases accordingly. A flourishing economy means better-performing companies, which consequently leads to higher salaries. People, therefore, start spending more money on things they do not need to survive.
When people have spare money they usually spend it on clothes or holidays. Many people purchase cars and other luxurious goods. That’s why, all these industries – luxury goods, automobiles, hotels, clothes, have a cyclical nature. They rise when the market rises and they suffer when an economy starts going down.
There are various measures and indicators which determine the type of stock. The three most important are:
- Systemic risk is one of the indicators which analysts use to determine whether a stock is cyclical or non-cyclical. It measures the volatility of a security compared to that of the market. A value that is more than one indicates that the security’s volatility is higher than the one of the market.
- Earnings per Share (EPS) is a market ratio that shows how much profit a company’s share earns. Usually, cyclical stocks tend to have more volatile EPS due to the fact that they are more closely correlated to market fluctuations.
- Price to Earnings Ratio (P/E) is a measure that shows the comparison between the price of a stock and its earnings. Cyclical stocks’ ratio is usually lower than the one of non-cyclical stocks. It’s one of the most common ratios when talking about stock investments.
Should I Buy Cyclical Stocks?
This question is something that any individual should answer themselves. But I will help you answer the question. In the previous paragraphs, we discussed the principle of cyclical stocks and how closely they are related to market movements.
Therefore, to trade these stocks, you need to know the market very well. You have to understand the business cycles, and when they are at their top and when they reach the bottom.
This is essential if you want to make the best of profit. Otherwise, you won’t be able to make a significant profit. It’s also important since this knowledge will protect you from losses.
Keep in mind:
It’s never black and white. Sometimes stocks start rebounding during a recession or going down during an economic boom. Why? There are many, many other factors that contribute to stock prices.
Here you will find information about the sectors and industries we consider cyclical. We have three main categories of cyclical stocks, therefore companies:
- Durables – these are companies that produce durable goods (more than three years lifespan). Examples include car manufacturers, furniture, appliances and many more.
- Non-durables – this category includes non-durable goods such as sports clothes.
- Services – here we list companies that provide their clients with services rather than goods. For example, companies in the film and entertainment industry, the digital space, etc.
Non-cyclical sectors include several sectors: Food Distribution, Beverages, Tobacco, Convenience Stores, Pharmaceuticals, Household Products, Utilities and others.
In my opinion, stocks, both cyclical and non-cyclical, should be a part of any investor’s portfolio.
To trade successfully, an investor needs a profound understanding of the market and its driving forces. Whether you opt for cyclical or non-cyclical stocks is a matter of personal choice. They can be both profitable as long as you understand the industry in depth.