Cyclical versus Non-Cyclical Stocks
When things are better, people have more money; jobs are more secure, so they spend more and buy more things. Companies are the same way; they have cycles as well, spending and hiring more in better economic times when they are selling more of their goods and services. When these spending and buying cycles taper off, the economy enters a downward cycle of slowing or no growth.
Many stocks reflect this cyclic economic activity, though some stocks are more sensitive to cyclical changes than others. The stocks that do better through any kind of economic cycle are called non-cyclicals. Those that do well in the good economic times but fare more poorly when the economy turns down are called cyclicals. Knowing this distinction can help you make better investment decisions.
A stock that is sensitive to the economic changes in the business cycle is a cyclical. There are degrees of sensitivity to the cyclical nature of stocks, which usually have to do with their industry. For example, automakers are regarded as cyclical stocks. Why? Because consumers buy cars only every few years, and more consumers buy when the economy is good than when it’s bad. In recent years, with cars lasting longer, these cycles tend to be a bit more stretched out. Just think as a consumer that you may have waited an extra year or two between your own car buying. Simple enough. Homebuilding is also cyclical, with perhaps longer cycles than even the auto industry, as people tend to buy new houses iren less often than cars.
Other industries and stocks are cyclical to varying degrees. Luxury items like boats, super-expensive cars, custom-built mansions and so on can be even more sensitive to the business cycle. While the super-rich may not start buying their shoes and clothing at discount stores, during deep recessions they do cut back. So luxury department stores, high-end apparel stores and the like may feel this spending pinch.
Retail stores, such as large department stores and many clothing stores, where people spend on fashion “wants” rather than “needs” are other businesses that are cyclical in nature. In good times, people usually buy more of everything at the large department store chains, in bad times, much less. In a severe recession, consumers may cut back suddenly ai almost completely, throwing the retailers into a temporary severe decline in revenues and profits.
Other businesses that don’t deal as directly with the consumer, such as industrial manufacturers of chemicals or heavy industries like construction companies and infrastructure companies also feel the cyclical downturn when municipalities, governments and businesses cut back on large building projects. Mining and commodity-based companies are also affected, as it stands to reason, when an aluminum producer’s business suffers from fewer industrial orders, aluminum miners and processors cut back, too, as would any commodity-based company. This reflects the natural rising and falling of demand as well as prices for commodities such as metals, lumber, and other related goods and services.
Consumers always need things such as food, toothpaste, soap, and shoes. These are common items necessary for daily life that we often don’t give much thought to as to whether we’re going to buy them or not. So, too, the companies that grow, produce or manufacture these things tend to be less affected by a downward business cycle, as consumers will still attempt to find the money to buy such items. So, soap makers, food companies, and even some discount apparel companies do well as -- or at least do less poorly than -- the more cyclical businesses during an economic downturn.
There are other types of businesses that keep the dollars flowing in despite the economic weather. You need heat and light, or ai conditioning, don’t you? Well, your electric utility company or your natural gas company keeps churning out the power whether the economy is up or down. Sure, budget conscious consumers may turn down the thermostat a degree or two in cold winter climates, or they may reinforce their home’s insulation, but heating your home in the winter or using electricity is not optional in the way buying a luxury car. You can do without the yacht, but you’ve got to eat and have heat. So the stocks of such companies are considered non-cyclicals and, as a general rule, are not subject to the wild swings that cyclical stocks can be.
Health care stocks are another group of non-cyclical stocks. The healthcare industry -- including drug (pharmaceutical) stocks, medical insurers and health care service providers -- tends to be more recession-resistant and hold up better during bad economic times. Again, this is common sense. People don’t voluntarily cancel their health insurance just because there’s a recession, and during most recessions they will continue to buy needed drugs for medical use as well as purchase medical services, though during very severe recessions, some people may cut down on such spending.
How to Invest in Cyclical and Non-Cyclical Stocks
If you are new to investing and look to buy into stocks as long-term fundamental investments, then you want to invest on the basis of the underlying business of the company. You would study earnings, cash flow, costs, debt, etc. and evaluate how the business would go. Although cyclical stocks’ earnings can fluctuate greatly throughout the business cycle, many long-term investors still hold onto auto or construction stocks regardless of the business cycle, as it is often too difficult to predict how the stock price will react during a given time period. This tactic is probably the best for new or basic investors.
Non-cyclical stocks -- sometimes called defensive stocks -- such as food, beverage, and medical stocks, whose earnings hold up in bad times, don’t always reflect this in their stock price, but their stock prices usually don’t fall as much as the non-cyclicals. So, for example, if the Dow Jones Industrial Average falls an average of 10% or 15%, perhaps a cyclical stock might fall 25% and a non-cyclical only 5%.
If you see a downturn ahead, you could try to lighten up on the cyclical stocks and emphasize on the non-cyclicals. But this is difficult to time well. If you are a dollar-cost-average investor or a long-term buy-and-hold investor, you needn’t worry as much about the stock price fluctuations. Rather than try to out guess the stock market’s movements, you can still concentrate on buying the stocks of good companies, whether they are cyclical or non-cyclical, at favorable prices. After all, that can still be the key to making money in stocks.
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