Economic Rhythms: Investing in Cyclical Stocks

Key Takeaways

• Because of cyclical stocks’ correlation to the economy – their inherent volatility — it can be difficult for investors to guess how one or more will perform.

• When economic growth slows, non-cyclical securities consistently outperform the market. In fact, they are virtually immune to broad economic changes.

• Industries that are deemed cyclical include automotive manufacturers, technology, materials, restaurants, hotel chains, furniture, airlines, travel, leisure, and retail, especially high-end clothiers.

There was once a common refrain about what then was the world’s No. 1 automaker: “What’s good for General Motors is good for the country.” While sweeping hyperbole, the saying spoke to the extent to which the corporation’s fortunes were entwined with the nation’s, or at least seemed to be.

It also brings to mind cyclical stocks, which, along with their companies, are directly related to the economy. In other words, such stocks rise and fall with the economy. 

With that said, here are economic rhythms: investing in cyclical stocks.

What are Cyclical Stocks?

Cyclical stocks represent companies that produce or sell goods or services that are in demand when the economy is doing well. In general, these stocks are highly sensitive to the economic cycle. As such, these companies may significantly decline during economic contractions. 

It is key for investors to understand clinical stocks because of their volatility and relative riskiness. Such stocks can offer rewarding investment opportunities but require thorough research and knowledge of prospective risks and rewards. 

How are Cyclical Stocks Different from Non-Cyclical Stocks?

When economic growth slows, non-cyclical securities consistently outperform the market. In fact, they are virtually immune to broad economic changes.

Non-cyclical stocks represent goods and services that are often referred to as consumer staples since they are always in demand. They are also called “defensive stocks” since they can defend investors against the impact of an economic slowdown. 

These securities are generally profitable, economic trends notwithstanding, because they make or distribute always-needed goods and services such as gasoline, water, power, pharmaceuticals/healthcare, and food. Soap, toothpaste, dish detergent, and shampoo, while non-durable, are considered essential because people generally do not wish to do without them.

An example of a non-cyclical company is a utility company – people require heat and gas or electricity. Because such companies provide a service that is used constantly, they tend to grow slowly and incrementally with no dramatic fluctuations, even when the economy grows. 

Regardless of one’s financial state, or the state of the economy, utilities are necessary. Thus, most people will generally pay those bills. That makes those stocks non-cyclical. 

What are Some Industries that are Considered Cyclical?

Industries that are deemed cyclical include automotive manufacturers, technology, materials, restaurants, hotel chains, furniture, airlines, travel, leisure, and retail, especially high-end clothiers.

Companies in these sectors track trends in the overall economy, which renders their stock prices significantly volatile. Economic growth is commensurate with cyclical stock prices. On the other hand, a souring economy means a drop in stock prices. From expansion to peak, recession, and recovery, cyclical stocks follow all the economic cycles.

Factors that Influence Cyclical Stocks

There are factors that impact cyclical stocks, including interest rate changes. Low interest rates mean low borrowing costs, which can result in newly stimulated economic growth. That can lead to heightened demand for cyclical sectors.

If rates go up, though, so does the cost of borrowing. In turn, that can unfavorably affect cyclical companies that depend on borrowing to finance their operations.

Consumer spending is another factor that affects cyclical stocks. When the economy is growing, people are more likely to buy discretionary items such as electronics or spend money on vacations. Such outlays can benefit cyclical industries such as hospitality or high-end retail.

When the economy goes south, however, people tend to reduce spending, which can have a negative effect on cyclical stocks.

Then there are global economic conditions, which can also affect cyclical stocks’ performance. If a recession is underway in a major global economy, for instance, it can result in flagging demand for goods and services provided by cyclical industries.

In addition, commodity prices influence cyclical stocks. In fact, cyclical and commodity companies both are more dependent on the commodity price or the underlying economy’s growth than on the characteristics of the companies themselves. Therefore, the value of an oil company, say, is inextricably tied to the price of oil, just as a cyclical company’s value is linked to how the economy is doing.

Risks and Considerations of Investing in Cyclical Stocks

The prices of cyclical stocks can be highly volatile since they are based on economic changes. Some investors are put off by such volatility. 

Non-cyclical stocks do tend to be more stable. However, cyclical stocks have the best potential for growth since they usually beat the market when the economy is robust. Thus, many investors choose to diversify their portfolios with cyclical as well as noncyclical securities.

Company-specific factors including market share, management decisions, and pressures from rivals could also impact the performance of cyclical stocks. Thus, investors should take time to evaluate individual enterprises before investing in their stocks.

In addition, cyclical stocks are frequently affected by interest rate changes. Interest rate increases cause borrowing costs to rise. In turn, this can negatively affect cyclical companies that depend on borrowing to keep operations afloat.

When individuals put off or cease purchasing items considered dispensable, revenues fall. This causes stock prices to drop. If the economic downturn is protracted, some of the companies may fail.

Overall, it is advisable for investors to assess their financial objectives and risk tolerance when mulling investing in cyclical stocks, and to grasp the prospective risks and benefits associated with such securities. 

Benefits of Investing in Cyclical Stocks

While no investment is risk free, there are potential advantages to putting capital in cyclical stocks, including higher returns. During times of economic growth, cyclical stocks could provide higher returns than other stock types. Why? Because cyclical companies’ earnings typically improve along with the economy, resulting in increased stock prices and possible investor gains.

Such stocks can also provide investors with opportunities for growth when the economy is expanding. The economy grows commensurate with demand for goods and services from cyclical industries.

In addition, some cyclical stocks provide dividends – a steady income stream. Investors who seek a regular cash flow from their holdings may find this particularly attractive.

Low valuation could be another benefit to cyclical stocks. When there is an economic downturn, cyclical stocks could be undervalued. In turn, this could give investors an opportunity to buy stocks at a lower price. If the economy strengthens, such stocks may subsequently rise in value, prospectively resulting in marked gains for investors. 

Investment Strategies to Consider for Cyclical Stocks

While investors cannot control economic cycles, they can adjust how they invest to the economy’s ebb and flow. That calls for an understanding of cyclical industries’ relationship to the economy. 

Also, creating an investment portfolio that includes a mix of cyclical and non-cyclical stocks can help to spread risk – thus mitigating exposure – and provide investment stability. Diversification can serve to shield against losses in one sector but provide opportunity for growth in another and can help protect against inflation.

Another strategy involves attempts to “time” the market. However, because of cyclical stocks’ correlation to the economy – their volatility — it can be difficult for investors to guess how one or more will perform. 

In addition, some investors engage in sector rotation – investing capital in and out of cyclical segments based on economic trends. An investor might home in on certain stocks when the economy is growing, for example, and pivot toward non-cyclical stocks when the economy contracts.

Then there is a strategy known as “dollar-cost average,” which entails regularly investing a fixed amount in a cyclical stock, no matter the market conditions. This approach could slash risk and flatten stock price fluctuations.

Buy low, sell high is a popular strategy for cyclical stocks. This approach calls for the investor to pay close attention to the stock market and economic trends, in addition to a willingness to hang onto investments for a longer period.

Diversifying Your Portfolio Outside of Just Cyclical Stocks 

Diversification – spreading one’s assets both within and among varying asset classes – is a hallmark of long-term successful investing.

The idea is to own a mix of assets that perform varyingly over time, but not too much of any single investment or type. After all, each asset type performs differently, depending on the economy, and each offering different potential for gains and losses. 

Such diversification does not exclusively mean a portfolio of cyclical and non-cyclical stocks. Alternative assets – those other than stocks and bonds – are increasingly popular as a way to reduce portfolio volatility and potentially deliver regular secondary income.  Note that not only can diversification help to lower overall portfolio risk, but it can lead to higher returns.

Alternative Assets and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $5000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Because cyclical companies follow overall economic trends, their stock prices are volatile. However, they can also provide opportunities for higher returns and growth.

By contrast, the state of the economy notwithstanding, non-cyclical companies produce goods and services that are always in demand, no matter the economy’s state. Be mindful, though, that the prices of such stocks will not markedly increase when the economy grows.

Note, too, that while cyclical stocks may be used to diversify one’s investment portfolio, so may alternative investments, but with generally lower volatility plus protection against inflation.