Cyclical stocks are companies that will mirror the current stage of the economic cycle, but should you be worried about investing in them?
Dec. 16, 2022
Cyclical stocks, to put it simply, are stocks that are directly affected by wholesale changes in the overall economy. Typically, they sell discretionary items that are often bought more while an economy is booming, but less during an economic recession.
Understanding Cyclical Stocks
The typical economic cycle has four distinct stages: expansion, peak, recession, and recovery. Cyclical stocks follow this cycle quite closely. When the economy is going through an expansion, people typically have more money to spend on non-necessary purchases. This will continue through the peak and cyclical stocks can see huge growth through these periods.
On the other hand, as the economy begins to contract and enter a recession, these non-essential expenses will often become the first thing consumers will cut back on. Spending ceases and these stocks can start to drop rapidly. In severe cases, the dip can be so large that once-profitable companies may even go out of business.
Examples of Cyclical Stocks
There are a massive number of industries that tend to do well while an economy is growing. These include restaurants, aviation, hotels, high fashion, and the auto industry to name but a few. The common factor among these industries is that they all provide goods or services that can be deemed non-essential purchases.
People may need to drive a car but they more than likely don't need to buy a brand new one. Everyone needs to be clothed but that can be achieved without going to high-end fashion stores. As a result, when the economy slows down people will stop spending their money on these particular goods and services.
Well-known examples of cyclical stocks include Delta Airlines, Chipotle, and Ford. These stocks can be volatile, particularly during times of economic uncertainty, but can offer great potential for growth.
Examples of Non-Cyclical Stocks
Contrary to this, non-cyclical stocks are considered secure regardless of how the economy is doing. They typically sell goods and services that are seen as necessities. These stocks are also called "defensive" stocks as they offer investors a defense against the changing economic tide. Utility companies (think electricity and gas) and grocery chains are two great examples of non-cyclical stocks. No matter how bad the economy is doing, people will still require food and power.
Well-known examples of non-cyclical stocks include Costco, Coca-Cola, and General Mills. These stocks offer stability throughout an economic cycle but lack any real sizeable growth potential.
Should I buy Cyclical Stocks?
Cyclical stocks can certainly be a very valuable part of any diversified portfolio but care definitely needs to be taken to manage their inherent volatility. Before investing in cyclical stocks, it would be worthwhile to take some time to determine your own level of risk tolerance. Cyclical stocks offer enormous growth potential but you need to be ready for their inevitable decline once the economy enters a downturn.
However, if you follow MyWallSt's 6 Golden Rules, you should be able to find companies that you're willing to invest in long-term. While we would certainly advise you to be cautious about the weight of cyclical stocks in your portfolio, we would never tell you to steer clear of what could be some amazing investment opportunities.
