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5 Key Traits Of Cyclical Stocks

Cyclical stocks are sensitive to economic changes, have high beta, concentrated in certain industries, show earnings fluctuation, and require precise investment timing

Economic Cycles and Stock Volatility

Cyclical stocks are very dependent on the phases of economic cycles. The high volatility of such investments may result in substantial losses or profits for investors depending on the state of the economy. For this reason, understanding the nature of this connection is essential for making informed investment decisions. The main characteristics of these stocks and the way they influence investment patterns are as follows:

High Sensitivity to Economic Changes

  • Cyclical stocks are highly dependent on the macroeconomic environment. For example, during the financial collapse of 2008–2009, the automotive industry representatives were among those whose stock prices dropped the most. In particular, General Motors and Ford have both lost significant value as people can no longer afford to buy expensive cars due to high unemployment rates and difficult economic conditions. However, when the economy recovers, such stocks also rise more quickly than others, allowing those who wisely invested in them to gain high profit.

Beta Value and Market Volatility

  • The value of beta in such stocks is traditionally high. By typical market characteristics, they are more volatile than the overall position of the market. For example, in times of economic growth, the beta of stocks related to consumer discretionary production is often higher than 1.5. This implies that such stocks are 50% more volatile than the market, and while they can increase at a faster rate during booms, similar tendencies occur during downturns. Therefore, the high volatility of these stocks also implies substantial losses or gains depending on the state of the local or national economy.

Industry Concentration

  • Finally, cyclical stocks are heavily concentrated in industries such as luxury goods, car manufacturing, and housing. For example, housing is a vivid indicator of economic cycles. Thus, during the house bubble burst of 2008, Lennar Corporation and PulteGroup businesses lost around 70% of their stock value. On the other hand, in times of recovery, the stocks of these businesses often flourish more than the market in general.

Earnings Fluctuation

  • Earnings of cyclical organizations vary significantly, following the overall tendency to the field in accordance with economic conditions. Thus, in times of recessions, Caterpillar Inc., a producer of construction and mining equipment, sees a drastic decline in the sales of their machinery, leading to significantly decreased earnings reports. On the other hand, in times of growth, the company may show large profits due to higher demand.

Precise Investment Timing

  • Because of these strong connections to the economy, the investments in cyclical stocks should be timed very precisely. For persons who entered the market in early 2009 and bought shares of automakers, construction companies, and other similar organizations, the profit will certainly be very impressive. However, inappropriate timing results in significant losses.

High Beta Value and Market Volatility

Cyclical stocks offer high beta, which is essentially a stock’s volatility concerning the market. It is an essential characteristic for investors to understand as it shows the proportion by which a stock will move relative to the market. Beta serves to measure the stock’s sensitivity to the particular index.

Definition of Beta Value

“Beta Value is significant as it denotes the relative sensitivity of the particular stock, to a particular index”. Therefore, a beta of a stock is the extent of its movement relative to the measure it is compared to the market. A beta that is higher than 1 means that the stock is more volatile than the market. Therefore if a stock has a beta value of 1.5, it is 50% more volatile than the market. Investing in high beta stocks is likely to result in major gains during the market upswings, and major losses during the downturns. Therefore, the crucial feature of a high beta stock is that it is unstable. A significant number of the cyclical stocks during the 2020 pandemic had high beta values and were prone to volatility. The stocks of the airline sector are a perfect example in this regard, with Delta Airlines having a beta of 1.4, which is quite generous. The stocks of the airline industry experienced massive price swings. Therefore, while investors who entered the market at the right time enjoyed significant advantages, those who exited at the wrong time experienced substantial disadvantages.

Investment Strategy

Investing in restaurants is one of the most viable strategies. Basically, these are cyclical stocks, which offer a high beta value. The recession is over, and the government is relaxing restrictions regarding how restaurants should operate. In addition, there is an improvement in the vaccine rollout. Therefore, it can be observed that the cyclical stock depends on the economic cycle, and a subsequent accurate analysis of the economic trends will inform the timing of entry and exit.

Beta Calculation and Analysis

Beta may be calculated by comparing historical prices of the stock in question to those of the market index. A higher beta value signifies that the risk potential and reward are also higher. The financial information available indicates that the beta for the technology sector is an average of 1.5, showing high volatility. For example, the beta of Tesla is 2.0, reflecting its performance in the given period. For the utility sector, the beta is usually 0.5, which is significantly lower, indicating that this sector is less volatile.

Diversification

It is essential to ensure that high beta stocks are balanced with low beta ones to avoid significant market movement risk. For instance, the tech stocks are unstable, while utilities have low levels of instability. Mixing the two such as a higher proportion of tech stocks with utility stocks ensures that the overall risk in the entire portfolio is significantly lower, implying that an investor is insulated from major losses.

Major Industries and Cyclical Stocks

Cyclical stocks are typically found in industries highly sensitive to economic changes. Major industries connected to cyclical stocks are presented below, along with the detailed examples.

Automotive Industry

The automotive industry is one of the most famous cyclical sectors. For example, during the economic expansion, when the economy is in the boom, and the consumer spends more money, such companies as General Motors, Ford, and others witnessed significant sales spikes. However, the 2008 global financial crisis, an event that caused automotive sales to plummet, the stock prices of these companies also experienced a severe decline. For instance, taking as an example the car marker Mazda Motor, Inc., the company’s stock prices went up again after 2009, when the U.S economy started recovering. This is explained by the emerging trends of increasing consumer spending riots2020.com/#3_Pandemic-Related_Unemployment. Thus, the mentioned industry stocks and the sector itself are highly cyclical.

Housing and Construction

The housing and construction industry is another example of a strongly cyclical feature. For example, during the boom of the economy, the demand for new houses and other construction works increases. The companies like Lennar Corporation, PulteGroup, and others have significantly increased their stock prices during the housing market boom around 2000. In contrast, such a significant event as “The 2008 Housing Market Crash” caused the stocks of these companies to plummet as the demand for housing dropped. After that, the housing and construction market started to recover, and so did the stocks of those companies.

Travel and Leisure

This industry is also very cyclical due to the nature of the service sphere. For example, when customers possess more money and are willing to spend for the sake of vacations and entertainment, such companies as Carnival Corporation, Marriott International, Inc., and others witness increased stock prices. With a similar understanding, the example of the COVID-19 pandemic of 2020 demonstrates the opposite reaction. After the worldwide travel ban had been set, the travel and leisure companies witnessed a significant decline in stock values. Later, after the situation was taken under control and the travel resumed, such companies were able to increase their stock prices again with a record spike in 2021.

Technology sector

Although this sector is not usually regarded as cyclical, some of the technology sectors demonstrate some cyclical traits. For instance, especially those parts of the innovative sector that are connected to consumer electronics and discretionary spending possess cyclical patterns. For example, during the economic upswings, certain companies like Apple, NVIDIA, and others increase their stock prices as people spent more on their innovative gadgets and gaming devices. At the same time, during the economic downturns, the sales decrease since people can afford less of discretionary spending.

Retail Industry

The retail industry, especially selling non-essential goods, also displays strong cyclical patterns. For instance, during the economic upswings, such retailers as Macy’s, Best Buy, and others can increase their stocks since customers start spending more money on their goods. At the same time, the economic downturns bring less money to the customers, which results in less retail revenues and declining stock prices. The 2020 COVID-19 pandemic is an example of this trait, which caused significant retail stocks plummeting. Later, after the vaccine invention and disease relief, with the returning economic upswing, the stock prices started increasing again.

Investment Returns and Risk Management

Cyclical stocks can potentially have high returns, but they involve considerable risks. Hence, proper risk management is necessary so that investors would take advantage of cyclical stocks opportunities and avoid their drawbacks. To manage the risks associated with the cyclical stocks, a strategy should be developed to cope with market volatility. Also, it is necessary to speak of the stock market movement that is typical for cyclical stocks.

Returns on Investment: General Overview

During the economic growth or expansion period, cyclical stocks can bring high returns to investors. As an example, S&P 500 Consumer Discretionary, which tends to have many cyclical stocks, grew by around 180% during the period of the economic recovery, which constitutes 2009-2013. Hence, if an investor has purchased consumer discretionary shares at market low, they could earn high returns by waiting for the general economic recovery.

Risk Management Strategies

Several risk management strategies may be approached by investors whose goal is dealing with the risks related to the cyclical stocks. First, diversification is the key to risk management. Risk can be divided into business risk and peak to trough risk, and these two types of risks can be managed when an investor properly manages the amount of money invested in various cyclical stocks and spread these investments across the cyclicals and non-cyclicals. Second, market timing is vital. To benefit from cyclical stocks, an investor should purchase them at the market peak and wait for the downturn. For instance, if cyclicals are to be sold in the anlaysis, it is necessary to approach the market during the first quarter after the expansion had spread over various markets. To follow this strategy, an investor should also be well-aware of economic indicators. Third, stop-loss orders can be used to limit the amount of money that can be lost if cyclical stocks movement occurs. Finally, economic indicators such as GDP and unemployment rates and business cycles, and such attribute of the economic cycle is consumer confidence, can help monitor market movement.

Things that happened in reality

An example of the mentioned above mismatch of the risks and the current investment approaches and strategies is presented by the airline industry. Zacks reports that airlines stocks sank because of the COVID-19 pandemic since people stopped traveling and going on vacations. When the market started reporting cases in the USA and the lockdown was imposed, the prices for airlines stocks like Delta Airlines and American Airlines fell by over 50%. Statista’s data from the 8th of July, 2021, claims that despite that, Delta Airlines’s stock is still down with 95.32 while American Airlines Group Inc follows it with a 91.6%. Thus, pandemic could have been avoided by stop-loss order or a properly diversified and analyzed portfolio of not only cyclical but also non-cyclical stocks. As for the long-term period, the fund managers or the whole teams study the business in terms of the business cycle. All industries depend on the business cycle, where each one is at different points in the cycle. If all possible information is studied, big players like large industries, retail chains, and the financial sector that interacts with people can always anticipate the change. For instance, the automotive sector has had a constant growth for the last hundred years, and, despite the short-term volatility, investors may always hope that their stocks will be gow in the long term. Similarly, all industries, for the majority of industries have been growing despite the temporary downturn or volatility.

How to Identify Cyclical Stocks

Identifying cyclical stocks involves an analysis of several key characteristics that indicate their sensitivity to economic cycles. They usually demonstrate high volatility patterns, significant price shifts in response to economic events, and often belong to specific industries. The main characteristics that may help determine of a stock is cyclical are the following.

Economic Sensitivity

The most typical and, apparently, the most evident property of a cyclical stock is its sensitivity to macroeconomic conditions. It means that these stocks are most likely to outperform during the economic expansion and suffer during economic downturns. For example, during the prior economic boom between 2003 and 2007, the stock price of the homebuilder Lennar Corporation experienced a dramatic growth due to increased demand in the housing market. Meanwhile, in 2008, the market crashed significantly, as the 2008 financial crisis hit the housing market.

Industry

Cyclical stocks are most often united in specific industries that are more affected by up- facto from the side of consumers and dependent on economic activities:

Automotive: Companies like Ford and General Motors have sales results differentiated by economic conditions. For example, in 2020, their automotive sales shrank due to the pandemic context, while in 2021, the companies managed to recover.

Housing and construction: Companies in this industry are likely to experience booms and manifestations along with housing market conditions. For instance, the stock price of PulteGroup had tripled from 2011 to 2013, as it was recovering from the 2008 recession.

Travel and leisure: Similar to the automotive companies, this niche is also dependent on consumer confidence. Thus, the stock price of Carnival Cruse Corp fell by over 70% in the early months of the COVID-19 pandemic, but then the economy, as well as cruise companies, started recovering and could attain similar results to the ones existing before.

Beta Value

The beta value can also help to determine the cyclical property of the stock. Beta measures the volatility of a company relative to the market, and if the beta is higher than one, the concern can be considered more volatile. For example, tech stocks, in particular NVIDIA, shares are primarily characterized by a beta above 1,5, which makes them highly volatile, and more likely to be cyclical.

Earnings

Cyclical stocks are mostly characterized by significant earning changes. It means that when the economy is performing well, such companies report unprecedentedly strong earnings, while on downturns the pattern is reversed. The example of such a company is Caterpillar Inc., as it is heavily affected by construction and mining conditions.

Historical Results

The probability of a stock being cyclical is also high if its historical results may suggest such an assumption. Accordingly, the stocks that were rising with the prior economic trend and declining during downturns can be considered cyclical. The examples that can be provided are Delta Airlines shares, as their results indicate a similar dependence on economy.

Consumer discretionary spending

Finally, it is worth mentioning that cyclical stocks are quite frequently united by their connection with discretionary spending. It is the type of spending that rises during the good periods and falls during recessions. For example, Macy’s Corporation retail company is also considered to be a cyclical stock.

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