Although investors cannot control the economic cycles, they can easily adapt their investment practices to suit their ebb and flow. However, adjusting to economic transitions needs a good understanding of how various industries are related to the economy. There are certain fundamental differences between companies that are affected by the economic changes and those which are practically immune from them.
One of the common and easiest classifications of stocks is cyclical and non-cyclical. The terms cyclical and non-cyclical denote how closely a company’s share is correlated to the fluctuations of the economy. Cyclical stocks and their companies have a direct relationship to the economic fluctuations, while non-cyclical stocks consistently outperform the market even when the economic growth slackens.
- Key Points
- Cyclical Stocks
- Non-Cyclical Stocks
- Examples of Cyclical and Non-Cyclical Stocks
- Cyclical stocks are volatile as they tend to follow trends in the economy
- Non-cyclical stocks generally outperform the market during an economic downturn
- Cyclical stocks belong to those companies that sell goods and services the consumers might buy when the economy is doing well, but not during downturns
- Non-cyclical stocks are of those companies that sell essential goods, including household non-durable goods such as soap, detergents, and toothpaste.
Let us take a closer look at these two types of stocks.
As the name implies, a cyclical stock has a highly correlated movement with the business cycle. Automobile stocks can be a good example of a cyclical stock as they then perform well when the economy is strong, and people are confident to spend.
In short, cyclical stocks are stocks of businesses that thrive during economic growth when consumer spending is high. Some of the typical cyclical stocks are of companies in the field of home construction, automobile, or even companies that manufacture high-value items such as boats or furniture. Apparel manufacturers can be included in this list as well because people tend to buy more clothes and shoes when the economy is strong, and they have more purchasing power.
One of the major characteristics of cyclical stocks is that they tend to do extremely well during economic upswings. This is because these businesses capture a great slice of spending as the consumers are confident enough to spend a larger portion of their earnings/savings on non-essential commodities. But, when there is an economic downturn, consumers stay away from these non-essential commodities and goods to set aside their earnings for what is essential. In such a scenario, these stocks tend to be in low demand.
Businesses in cyclical industries often face fluctuating demand for their products and services. Their demand is closely tied to consumer confidence and the robustness of the overall economic environment.
Characteristics of Cyclical Stocks
They follow the economy - cyclical stocks follow the trends in the general economy thereby making their stock prices highly volatile. The prices of cyclical stocks go up when the economy grows. However, when the economy takes a downturn, the cyclical stock prices will drop. These stocks have a close correlation with the movement of the economy and hence they follow every economic cycle such as expansion, peak, recession, and subsequent recovery.
They deal in non-essential goods and services - cyclical stocks belong to companies that produce or sell non-essential goods and services which tend to be in demand when the economy is faring well. This includes businesses such as restaurants, hotels, airlines, furniture, high-end apparel, and automobile manufacturers, among others. These goods and services are the first ones that consumers will stay away from when times are tough.
Consumer behaviour affects share prices - when people postpone or stop buying any items they deem non-essential, the earnings of the companies that produce and sell such items fall. This will, in turn, put pressure on their stock prices, which start to fall. In the event of a lengthy recession, some of the businesses might go out of business as well.
- Cyclical industries make or sell products that consumers could live without or delay buying when the times aren’t great. Examples include travel and tourism, construction, automobile, and so on.
- Cyclical stocks move up and down with the economy. If the economy performs well, the stocks will do well, and vice versa.
- Predicting opportunities in cyclical stocks is sometimes hard as they have a strong correlation with the economy. Any unexpected economic changes will affect them as well.
- It is difficult to guess how well a cyclical stock will perform under volatile economic conditions.
Non-cyclical stocks are the exact opposite of cyclical stocks. Often called defensive stocks, they are stocks of businesses that operate in industries that perform well regardless of the economy. You’ll find that these are businesses that deal in essential goods, such as utilities and household products. Whatever the state of the economy, consumers cannot do with the basic goods and utilities. Even if the economy is performing poorly, consumers continue to food, household products, and other essential items.
In short, a non-cyclical stock has truly little or no correlation with business cycles. Consumer staples are good examples of non-cyclical stocks as people tend to buy them regardless of the economy. Whether the economy is strong or not, consumers still buy staple products such as detergents or toothpaste. These are essential goods such as power, water, gas, food, and other essential household products that people will buy whether the economy is performing well or not.
Furthermore, if the confidence in the economy is at a low level, there is always a risk of reduced salaries, job cuts, and so on. In such a circumstance, consumers will look to set aside whatever money they have to ensure the availability of essential goods. This would in turn lead to an increase in the share prices of non-cyclical stocks, which would then lead to cyclical stocks losing their value.
Businesses belonging to non-cyclical industries enjoy a sticky demand. It means that no matter what the situation of the economy is, there is always a demand for their product or service. For instance, although non-durable household goods such as soap, toothpaste, detergent, shampoo, and dishwashing solution may not seem essentials like food, they really can't be sacrificed. Whether people earn more or less, they will buy these items as they are essential to keep themselves and their utensils, clothes, etc clean. No one will wait for the economy to get stronger to buy a detergent or shampoo.
Characteristics of Non-cyclical Stocks
They are defensive – non-cyclical stocks are often called defensive stocks because they protect the investors from the effects of an economic downturn. As the businesses enjoy steady demand even when the general economic outlook is sour, they offer a safe and dependable option to invest.
They are unavoidable services – another example of non-cyclical stock is that of utility companies. No matter what the condition of the economy is, people would need power, water, and heat to keep themselves going. Although these services might see a seasonal rise in demand – higher heating requirements during winter and more water during summer – they enjoy a conservative growth and undergoes little fluctuation.
Important points to note
- Non-cyclical stocks provide safety. Their prices will not skyrocket when the economy grows, but they will also not bottom out during a recession.
- Investing in non-cyclical stocks means lower chances of losses at any point in time. They are not highly volatile like cyclical stocks.
- Non-cyclical industries produce and sell essential goods and services people will use even when money is tight.
- Non-cyclical stocks offer steady earnings irrespective of the economic condition.
- Non-cyclical stocks generally outperform the market during economic slowdowns
In short, non-cyclical securities are usually profitable irrespective of economic trends because they produce or distribute essential goods and services. This includes goods and services we always need, such as food, power, water, and gas.
Examples of Cyclical and Non-Cyclical Stocks
- Automobile and components
- Consumer durables and apparel
- Consumer services
- Diversified financial
- Capital goods
- Commercial and professional services
- Software and services
- Hardware and equipment
- Semiconductors and equipment
Non-Cyclical Stocks or Defensive Stocks
- Food and staples
- Food, beverage & tobacco
- Household and personal products
- Health care equipment and services
- Pharmaceuticals, biotechnology, and life sciences
- Telecommunication services
- Media and entertainment
As you can see, most of the industries in the former list tend to perform very well when the economy is robust and growing. Of course, there could be some instances where a few industries like technology or finance continue to do better despite the economic downturn. Specific companies seem to enjoy investor confidence even when things aren’t going well with the industry as a whole. Such cases should be considered an exception and not a rule.
A keen observer of the market would notice that the cyclical stocks move with the economy, growing very well one day and dropping down the other. However, the non-cyclical stocks will remain more or less steady at all times. Although their growth rate might not be high or exponential in any way, they will not fall much even during really bad times. So, they are your safe bets if you are looking to invest in stocks. A good idea would be to go for a mix of cyclical and non-cyclical stocks in your portfolio to enjoy some profits without risking your entire investment.
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