Cyclical Stock: What It Is, Examples, Risk and Return Potential

What Is a Cyclical Stock?

The price of a cyclical stock is affected by macroeconomic or systematic changes in the overall economy. Cyclical stocks are known for following the cycles of an economy through expansion, peak, recession, and recovery. Most cyclical stocks involve companies that sell consumer discretionary items that consumers buy more during a booming economy but they spend less on them during a recession.

Understanding Cyclical Stocks

Companies with cyclical stocks include car manufacturers, airlines, furniture retailers, clothing stores, hotels, and restaurants. Consumers can afford to buy new cars, upgrade their homes, shop, and travel when the economy is doing well.

These discretionary expenses are some of the first things consumers cut when an economy does poorly. Cyclical stocks can become completely worthless if a recession is severe enough and companies may go out of business.

Cyclical stocks rise and fall with the economic cycle. This predictability in the movement of their prices can lead some investors to attempt to time the market. They buy the shares at a low point in the business cycle and sell them at a high point.

Investors should use caution about the weight of cyclical stocks in their portfolios at any point in time but this doesn't mean investors should steer clear of these stocks completely.

Special Considerations

Cyclical stocks are seen as more volatile than noncyclical or defensive stocks, which tend to be more stable during periods of economic weakness. However, they offer greater potential for growth because they tend to outperform the market during periods of economic strength. Investors seeking long-term growth with managed volatility tend to balance their portfolios with a mix of cyclical stocks and defensive stocks.

Investors frequently choose exchange-traded funds (ETFs) to gain exposure to cyclical stocks during expanding economic cycles. The SPDR ETF series offers one of the most popular cyclical ETF investments in the Consumer Discretionary Select Sector Fund (XLY).

Cyclical vs. Noncyclical Stocks

The performance of cyclical stocks tends to correlate with the economy but the same can't be said about noncyclical stocks. These stocks tend to beat the market regardless of the economic trend, even when there's a slowdown in the economy.

Noncyclical stocks are also referred to as defensive stocks. They encompass the consumer staples category with goods and services that people continue buying through all types of business cycles, even economic downturns.

Companies that deal with food, gas, and water, such as Walmart, are examples of those that have noncyclical stocks. Adding noncyclical stocks to a portfolio can be a great strategy for investors because it helps hedge against losses sustained by cyclical companies during an economic slowdown.

Example of Cyclical Stocks

Cyclical stocks are often further delineated by durables, nondurables, and services. Durable goods companies are involved in the manufacture or distribution of physical goods that have an expected life span of more than three years. Companies that operate in this segment include automakers such as Ford, appliance manufacturers like Whirlpool, and furniture makers such as Ethan Allen.

The measure of durable goods orders is an indicator of future economic performance. It may be an indication of stronger economic activity in the ensuing months when durable goods orders are up in a particular month.

Nondurable goods companies produce or distribute soft goods that have an expected life span of fewer than three years. Examples of companies that operate in this sector are Coca-Cola and Procter & Gamble.

Services is a separate category of cyclical stocks because these companies don't manufacture or distribute physical goods. They instead provide services that facilitate travel, entertainment, and other leisure activities for consumers. Walt Disney (DIS) is one of the best-known companies operating in this space. Also falling into this category are companies that operate in the digital area of streaming media, such as Netflix (NFLX).

The Bottom Line

A cyclical stock moves in sync with trends in the economy. The price soars when the economy is flourishing, but it can just as easily tank in times of recession. These stocks tend to be companies that produce and sell products that are discretionary rather than necessary components of life. Think restaurant chains rather than groceries.

Cyclical stocks tend to produce high returns but this is confined to times of economic strength. They'll tank when the economy struggles. They're volatile and should be balanced with noncyclical stocks in a portfolio.