What are Cyclical Stocks and Should You Invest in Them?
Source: Pexels

What Are Cyclical Stocks and Should You Invest in Them?

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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?

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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.

What are Cyclical Stocks and Should You Invest in Them?
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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.
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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.

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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.

What are Cyclical Stocks and Should You Invest in Them?
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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.

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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.

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