Finance

What are Cyclical Stocks?

Cyclical Stocks

There are certain stocks in the stock market that function in relation to the economic/business cycles. They are known as called “Cyclical Stocks.” The cycles of the economy cannot be controlled by investors, however, their investment strategies can be tailored to its rise and fall. There is a myriad of different companies listed and traded every day in the stock market, and the stocks of these listed companies can be classified broadly into two categories: cyclical stocks and non-cyclical stocks. Let’s look a little further into cyclical stocks and try to understand the investor’s effect and how they do it.

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What is Cyclical Stock?

A stock whose prices follow the course of the economic cycle is commonly referred to as Cyclical Stock. It is highly correlated with the activity of the economy. The price of such a stock is influenced by macroeconomic variables such as the economic activity of a country. During a recession, a cyclical company’s profits tend to drop and so does the company’s share price. Similarly, during an economic boom, the share price goes up. They are highly dependent on the fluctuations of the economy. This perceived predictability of stock price volatility has led some investors to seek to time the market. Hence, they buy the stock at a low point in the market cycle and sell them at a high point to make maximum profit.

What’s the difference between cyclical and non-cyclical stocks?

The word cyclical or non-cyclical means how correlated a company’s share price is to the economic changes. Contrasting cyclical stocks, non-cyclical stocks outperform the market during economic slowdowns and generate profit regardless of the economic state. They are also known as defensive stocks. These companies are into the production of necessary goods like utilities, which are purchased whether the disposable income of the population increases or decreases.

Examples:

Companies producing goods or services that are not a necessity come under Cyclical Stocks like automobile manufacturers, hotels & restaurants, airlines, etc.  During a recession, the purchasing power of the consumers is low and hence they refrain from purchasing the above-mentioned goods and services to save up money. Hence, the profits of these companies decrease and so does their share price. Companies engaged in the manufacturing of vehicles such as cars and bicycles are examples of large cyclical stocks. Consumers only want to purchase vehicles when the market is booming so they have sufficient disposable income. There is a range of other cyclical stocks in addition to car manufacturers, including real estate developers, cement manufacturers, hotels and restaurants, etc.

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Bottom line:

Investing in cyclical stocks during a recession often leads to good capital gains during a revival of such an economy, as demand increases and hence has a positive effect on the stock prices. Although they can produce good returns on investment, they are often very volatile and vulnerable to unforeseeable changes in their stock prices. In contrast, adding non-cyclical stocks to a portfolio is often an excellent strategy for investors because it helps hedge against losses sustained from cyclical companies during an economic slowdown. The trick lies in the strategic timing of the market as per the country’s economic cycle.

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

 

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