When the COVID-19 pandemic hit in 2020, the stock market crashed as a whole. But some industries, like dining and airlines, were hit especially hard, while others, like life and health insurance, remained relatively unaffected.
All stocks are somewhat volatile, meaning their price isn’t set and changes based on market conditions. However, some stocks are more volatile than others, returning market-beating gains when the economy is booming and heavy losses in a recession. These are known as cyclical stocks.
Buying and holding a diversified portfolio index funds can often be a better and safer investment strategy than picking individual stocks and trying to time the market.
For investors who have the risk tolerance for individual stocks and don’t mind paying attention to economic and market cycles, cyclical stocks have the potential to add gains to their portfolios. But experts warn against trying to time the stock market, and for many investors, a strategy of buying and holding a diversified portfolio of low-cost index funds may offer similar returns for much less risk.
Here’s what you need to know about how cyclical stocks work, and what you should consider before you invest in them.
What Are Cyclical Stocks?
In general, cyclical stocks are more sensitive to economic cycles, says Kevin Matthews II, a former financial advisor and author of “From Burning to Blueprint: Rebuilding Black Wall Street After a Century of Silence.”
“When a company’s stock is considered cyclical, it tends to go up in price when the economy is said to be thriving or recovering from rough times,” says Mabel Nuñez, founder of Girl$ on the Money, a financial education website aimed at helping women invest. “However, the company’s stock tends to decline when the economy goes through a downturn or any sign of uncertainty.”
Cyclical stocks vs. non-cyclical stocks
While NextAdvisor’s preferred investing strategy involves creating a diversified portfolio with low-cost index funds to hold for the long term instead of trading individual stocks, understanding the different types of stocks can help you make more informed decisions about your investment strategy. This includes knowing the difference between cyclical stocks vs. non-cyclical stocks.
It’s worth noting that all investments are to some degree volatile, meaning that they could lose or gain value at any time, unlike cash in a savings account. But some types of stocks are more stable than others.
While cyclical stocks follow economic trends and cycles, non-cyclical stocks are more consistent throughout economic downturns and aren’t as affected by economic downturns, Nuñez says. Cyclical stocks are more prone to boom and bust pricing and can experience wild swings as the economic situation changes.
Non-cyclical stocks are sometimes called “defensive stocks” and have a greater degree of stability, even in the face of economic uncertainty. “This is because non-cyclical stocks are generally in the business of providing essential non-discretionary goods like groceries and utilities,” Matthews says.
What Companies and Industries Are Considered Cyclical?
“For the most part, companies that depend heavily on disposable income often fall into the category of cyclical stocks,” Nuñez says. “For example, companies within industries such as entertainment, travel, leisure, luxury, retail, restaurant, technology, among many others, fall into the cyclical category,” she adds.
Some of the common industries considered cyclical include:
- Auto components: Revenue for auto parts manufacturing dropped in 2020 as unemployment rose and consumer and business spending fell due to the coronavirus outbreak. Some auto-parts related companies might include automotive parts retailers AutoZone (AZO) and O’Reilly Automotive (ORLY), as well as auto parts manufacturer Tenneco (TEN).
- Construction: The housing market historically accounts for about 60% of construction spending in the United States, and it’s a volatile market. Builders and materials providers can be impacted by economic cycles and changes in homebuying trends. Some related companies include construction machinery company Caterpillar (CAT), construction equipment rental company United Rentals (URI) and residential homebuilder D.R. Horton (DHI).
- Semiconductor: The relatively short lifespan of technology items contributes to the wide swings and cyclical nature of the semiconductor industry. Some related companies include wireless technology company Qualcomm (QCOM), semiconductor company Advanced Micro Devices (AMD), and graphics card maker Nvidia (NVDA), which saw demand earlier in 2021 due to crypto mining and the excitement around cryptocurrency investing.
- Airlines: As people have more money to spend on non-essentials like travel, airline stocks are likely to see an improvement in performance, says Matthews. As travel slowly returns, Airline stocks that may be affected include Delta Air Lines (DAL), Southwest Airlines (LUV) and United Airlines (UAL).
- Hotels, restaurants and leisure: Other travel and leisure stocks, including hospitality stocks, struggle when people have less to spend. The hotel industry, for example, took a hit in 2020. And, while it’s recovering in 2021, the American Hotel & Lodging Association’s industry forecasts say it will take until 2023 to reach pre-pandemic levels. Examples of these types of stocks include Brinker International (EAT), the parent company of restaurant Chili’s, travel shopping company Expedia (EXPE), and hotel chain Hilton (HIL).
- Textile, apparel and luxury goods: Luxury goods do well when the economy is booming, Nuñez explains, while people cut back on their clothing purchases when recession hits. Some stocks in this area include Capri Holdings (CPRI), which owns the luxury fashion brand Jimmy Choo, luxury home goods company RH (HR), and textile maker Unifi (UFI).
Advantages of Cyclical Stocks
The biggest advantage to cyclical stocks is the potential for growth during times of economic growth. Even though these stocks drop in recessions, Matthews suggests that those with the right risk tolerance could benefit.
“Recessions, at least historically, only happen once a decade and last 18 months on average,” says Matthews. “If you have the tolerance for volatility, you may find yourself winning more times than not,” he adds.
However, buying cyclical stocks is in no way required to get a good return on your investment. The S&P 500, which tracks the entire stock market, had an average annual return of 13.6% for the past ten years, according to a 2020 report by investment bank Goldman Sachs. For many long-term investors, such as those saving for retirement, buying and holding low-cost index funds that track the S&P 500 may offer similar rewards in the long term for less work and less risk than trying to time the market.
Disadvantages of Cyclical Stocks
One of the biggest issues with trying to invest in cyclical stocks is that it encourages investors to engage in behavior that gets very close to market timing, Nuñez points out.
“There is absolutely no way to time the stock market or know with any certainty what a stock will do from one day to the next,” she says.
It’s also easy to get spooked when trying to time the market with cyclical stocks, and it could result in selling low and losing out, rather than staying the course, according to Matthews.
How Investors Can Benefit from Cyclical Stocks
“If an investor is strategic and focused on taking full advantage of cyclical stocks, it is possible to take advantage of the cycle, buying during the rise and start selling when things change,” Nuñez says. “However, this is not an easy task,” she adds.
Indexers are already probably holding cyclical stocks as part of their index funds or ETFs, says Matthews. For those who want more exposure to cyclical stocks, but are wary of picking investments, Matthews suggests looking into a consumer discretionary ETF with low fees.
In the end, though, both Nuñez and Matthews suggest taking a step back and considering stocks from great companies that you can feel comfortable owning for years, without the need to try and follow cycles.