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 There is no doubt that the stock market presents us with a variety of investment opportunities nearly every trading day and one of those opportunities you should know about has to do with cyclical stocks. As consumers, we are pretty much at the mercy of large economic swings or cycles. But as investors we realize these same economic cycles provide us with chance to grow our investment returns or protect ourselves - if we know what to look out for.
Cyclical Stock Theory
The concept behind cyclical stock theory is pretty simple and it goes something like this: The financial health of some companies move in sync with the health of the economy, while other companies are relatively unaffected by economic downturns or surges. By understanding this cyclical relationship, investors can maximize the total return on their portfolio of stocks.
Identifying Cyclical Stocks
We're going to discuss how investors can capitalize on cyclical stocks and non-cyclical stocks later on, but first we need to figure out how to identify these stocks. If we had to, we can split the universe of stocks into two broad categories:
Cyclical Stocks
Cyclical stocks are those companies whose financial well-being moves in sync with economic cycles. They thrive during upswings and suffer during downswings - sometimes significantly. These companies generally manufacture goods, or provide services, that are considered luxury items or non-essential in nature.
These companies thrive during economic upswings because consumers have more discretionary income, or money, to spend. They buy more cars, eat at upscale restaurants, take exotic vacations, and buy more expensive clothing. So when times are good, these companies thrive because the demand for their products and services surges.
Cyclical stock industries are often associated with companies that produce durable goods - items that are made to last a long time such as refrigerators, cars, and air conditioners. During downturns in the economy, consumers may decide to have these goods repaired instead of replaced. They'll hold off on buying a new car for a couple of years until the economy turns around.
In the service sector, the travel industry is considered a good example of a cyclical service - especially when it comes to flying to exotic getaway locations. Once again, this type of service would suffer during economic downturns, and thrive when the cycle reverses itself and times are good.
Non-Cyclical Stocks
Non-cyclical stocks are stocks of those companies whose financial health does not depend on the economy. They produce goods or services that consumers are going to buy because they are necessities or non-discretionary expenses.
Non-cyclical stocks are not affected during economic downturns or upswings because consumers pretty much have to buy their goods and services. And they are not going to buy more just because they've got more money to spend. The classic example of non-cyclical stocks includes utilities - natural gas, heating fuel oil, electricity, and water.
Another class of non-cyclical stocks involves companies producing what are called non-durable goods. Again, the classic examples include household non-durable goods such as soap, detergent, toothpaste and most food items. These are essential household items that most consumers will purchase even if money is tight.
Investing In Cyclical and Non-Cyclical Stocks
Now that we understand how to identify cyclical and non-cyclical stocks, how can we use this information to maximize the return on our investment portfolio?
When to Buy Cyclical Stocks
If we know that cyclical stocks thrive when economic times are good, then the best time to invest in these companies is during economic upturns. For example, the ideal time to purchase stocks that are affected by economic cycles is right after the economy seems to be coming out of a recession.
That's because consumers have been holding off buying their new cars for a couple of years and they sense good times are on the horizon. For that reason car manufacturers will often see a surge in demand for their cars right after a recession.
It also is worth mentioning that some investment advisors such as Peter Lynch recommend avoiding cyclical stocks altogether. The thought here is that the returns from cyclical stocks are simply not reliable enough to hold in your portfolio.
When to Buy Non-Cyclical Stocks
Quite frankly it's always a good time to buy non-cyclical stocks. If you find a non-cyclical stock that has good growth potential, it's just going to keep on growing regardless of the economy.
The best time to buy non-cyclical stocks is just before the economy enters a downturn. That's the reason investors sometimes refer to non-cyclical stocks as defensive stocks - they can provide investors with a safety net during turbulent times. During economic downturns utilities are particularly attractive to investors because of franchise territory protections, the essential nature of their products, and the fact they are usually high dividend paying stocks.
Cycles of the Economy
When it comes to predicting the next cycle of the economy, you're going to have to do that research elsewhere. But once you're in a cycle, it's pretty easy to figure out if the good times are rolling or not. The point of this article is that investors, armed with the knowledge of when to buy cyclical stocks, or when to avoid them, can make much more informed investment decisions.
You can use the economic cycles to your advantage when selecting stocks - that's just one form of "timing the market." And at the very least you have a better understanding of how the economy might affect a stock you're evaluating - either positively or negatively.
About the Author - Buying Cyclical Stocks
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