Every economy goes through a cycle of expansion and contraction. This cycle impacts stock markets, with cyclical stocks weakening in a downcycle and strengthening in an upswing. What are cyclical stocks?
Cyclical stocks are for companies whose fortunes depend on the economic cycle. Typically, these companies sell discretionary products, for which demand falls when consumers have less money to spend. Conversely, defensive or non-cyclical stocks are for companies whose demand isn't affected much by the economic cycle. That said, almost every business has some degree of cyclicity.
Cyclical stock examples
The following stock categories would classify as cyclical:
- Consumer discretionary. The demand for consumer discretionary goods and services fall in a recession. People tend to shun non-essential expenses during a recession to save money.
- Basic materials. Stocks of companies involved in basic materials such as steel, copper, and cement are also cyclical. The demand for these products falls in a recession due to lower demand from end-user industries.
- Real estate. The housing sector is among the worst affected in a recession. Lower home building activity also impacts ancillary industries.
- Industrials. Industrial stocks are closely tied to the economic cycle.
- Energy. As oil demand falls in a recession, energy stock prices fall.
- Financial services. In a recessionary environment, banks tend to see more delinquencies, which impacts their profitability.
- Semiconductors. While tech stocks are largely noncyclical, semiconductor stocks are cyclical.
The #MysteryBroker says rotation into small-cap/value "will likely last many years." He's preferred cyclical/value stocks since the spring, and doesn't see current Covid surge derailing economic recovery or markets much given visibility toward treatments and vaccines..— Michael Santoli (@michaelsantoli) November 16, 2020
Best cyclical stocks
When searching for the best cyclical stocks, look for companies that have a lower cost structure than peers. As the economic cycle turns for the worse, companies with low-cost operations can better cope than peers that have high operating and financial leverage.
However, in an upcycle, stocks with higher operating and financial leverage can give good returns. If you're seeking returns across the business cycle, you should look for companies with strong balance sheets and lower costs.
Cyclical energy stocks
In the energy space, oil prices have tumbled in 2020. The sector also faces long-term headwinds from soaring sales of electric vehicles. The Biden administration is expected to focus on the nonrenewable energy sector. While this shift could be negative for domestic players, it may support energy prices. Oil giants such as BP, Shell, and ExxonMobil could be good energy cyclical stocks in such a scenario.
In industrials, auto stocks such as Ford and equipment makers such as Caterpillar look like good cyclical stocks. Also, airline stocks could be strong bets amid news of COVID-19 vaccine development.
My contrarian view is that the eventual pick in cyclical rotation could be index bearish as top 5 stocks are 18% of spooz and money will be coming out of them in sustained rotation environment— Igor Schatz (@Copernicus2013) November 17, 2020
Cyclical stock ETFs
There are several cyclical stock ETFs. The SPDR S&P Metals and Mining ETF invests in a basket of U.S.-based metal and mining companies, and the Consumer Discretionary Select Sector SPDR Fund gives you exposure to cyclical consumer discretionary stocks. The Invesco Dynamic Leisure and Entertainment ETF could be a play on the COVID-19 vaccine.
The iShares US Home Construction ETF and the SPDR S&P Bank ETF are other cyclical funds. Although cyclical stocks can be riskier than defensive stocks, if you can identify trends in the economic cycle early, cyclical stocks can pay off.