Cyclical stocks and industries: what you need to know
Whenever a macroeconomic event occurs, the price of certain stocks and sectors can be impacted – these are known as cyclical stocks. Learn more about what cyclical stocks are and how you can trade them.
What are cyclical industries and sectors?
Cyclical industries are those that are economically sensitive. This means they follow the ups and downs of the economy as a whole – becoming profitable during periods of prosperity and inactive during downturns.
This cycle is largely down to consumer spending. If a good or service is seen as a discretionary expense – an optional cost – then the companies involved would usually only see profitability if consumers have sufficient incomes.
Common examples of cyclical industries include automobile manufacturers, luxury goods producers, airlines, hotels and restaurants. When consumers have excess capital, they are more likely to make extravagant purchases or go on holidays, but during times of economic hardship consumers tend to stop spending and start saving.
What are cyclical stocks?
Cyclical stocks are units of ownership in these companies whose profits depend on the business cycle. The price of cyclical stocks usually rise in periods of economic boom – and can even outperform the wider market. But their value usually falls during downturns, in line with sales and profits.
To illustrate the ups and downs of cyclical stocks, we’ve plotted the share price of luxury goods producer Burberry (BRBY) against the FTSE 100 – a common benchmark for the health of the UK economy – from May 2018 to May 2020.
From the price chart, we can see that when the FTSE is stable or rising in price, the value of BRBY shares also rises. But at the end of the two-year time frame – during the 2020 coronavirus market crash – both the FTSE and BRBY fall in value. Although this was part of a wider stock market sell-off, other stocks fared far better as they were not reliant on the business cycle for profit.
Cyclical vs non-cyclical stocks
Non-cyclical stocks – also known as defensive stocks – are the shares of companies that tend to be profitable regardless of the state of the economy. Unlike cyclical stocks, they produce the goods and services that society can’t do without, such as utilities or food companies.
This means that the price of defensive stocks will likely remain stable, or even rise, during periods of increased volatility. As a result, traders often use defensive stocks as safe havens or to hedge against falling markets.
Both share prices remain stable while the FTSE sees little volatility, but as soon as the FTSE declines in value, Burberry shares fall while Ocado shares soar.
Amid the coronavirus crisis, consumers started to depend on online delivery as a means of getting food and essentials while implementing social distancing rules – making Ocado an extremely successful defensive stock over this period. Meanwhile, luxury goods were out of favour.
What you need to know before trading cyclical stocks
Cyclical stocks are volatile
Cyclical stocks are often far more volatile than non-cyclical stocks because they see significant growth during periods of economic health, and rapid declines during downturns.
Their volatility makes them particularly interesting for shorter-term trades to capitalise on intraday falls or to hedge against losses to your existing shareholdings. Using derivatives, such as CFDs, would enable you to trade both rising and falling markets.
For longer-term trades, you might need to consider ways to diversify your portfolio as cyclical stock volatility does create risk.
There are different ways to find cyclical stocks
There are various indicators that can be used to identify cyclical stocks. Two of the most common are beta value and earnings per share.
Beta value is a measure of a stock’s volatility in comparison to the rest of the market. Usually, a benchmark, such as a stock index, is used to assess a company’s deviation from the norm.
If a stock has a beta of one, then its volatility is equal to the rest of the market. A beta of less than one would mean the stock is less volatile that the market – which is likely the case with defensive stocks. And a beta of more than one would mean the stock has a higher level of volatility, which is usually a good indicator of a cyclical stock.
For example, if a cyclical stock has a beta of 1.5. This would mean for every 10% move in the underlying benchmark, the stock would have moved by 15%.
Earnings per share
Cyclical stocks’ earnings per share (EPS) can vary significantly from quarter to quarter because their profit and loss is so sensitive to economic health.
You could look at the price-to-earnings ratio (P/E ratio), which compares EPS to the stock’s value. A low P/E ratio compared to competitors would mean that you’re paying less for each pound of profit generated – suggesting that the company is undervalued. Cyclical stocks tend to have a far lower P/E ratio as a result of fluctuations in both their EPS and stock price.
Cyclical stocks outperform in periods of growth
Cyclical stocks are known for having a better rate of growth than other stocks during periods of economic strength. While non-cyclical industries tend to have stable profits over time, cyclical stocks experience extreme booms and outperform their benchmarks in economic upturns.
For example, airlines and other companies in the travel sector can see huge influxes of profit as spending on holidays increases during a period of prosperity. But whenever the economy constricts, these stocks feel the squeeze as holidaymakers switch to staycations and money saving.
Buying and selling cyclical stocks is all about timing
The somewhat predictable cycle of these discretionary stocks leads to a lot of attention from traders who aim to buy and sell positions at the perfect time in the cycle.
If you wanted to buy cyclical stocks, you might consider attempting to ‘buy at the bottom’ – finding the lowest point of an economic downturn when the stock will be of lower value. You’d then aim to take advantage of its recovery and upswing in a period of economic growth.
Once the stock has reached its full growth potential, you’d seek to identify its peak and sell before the next economic slump.
But remember, opening a position at the wrong time could result in significant losses if the market moves against you – making it important to manage your risk appropriately with stops and limits.
A great way of identifying these tops and bottoms is through technical analysis – the use of indicators and tools to find key price points in historic data. The theory behind technical analysis is that patterns will repeat themselves, so previous price levels can inform entry and exit points for new trades.
Diversification can help manage cyclical stock risk
It’s important to be careful about the portion of your portfolio that you assign to cyclical stocks at any given time. While it’s useful to have a number of cyclical stocks in your portfolio for their growth potential, it’s necessary to balance that with the potential risk associated with their volatility.
To build a portfolio with cyclical stocks – or any stocks for that matter – you need to diversify your exposure. This would mean trading a mix of cyclical and defensive stocks – as well as other asset classes.
During a period of economic prosperity, both types of stocks have the potential to earn you profit. However, if a period of economic downturn did occur, then your defensive stocks would likely offset some of the loss caused by any cyclical stocks you held a position on.
Cyclical stocks to watch
The best cyclical stocks to watch will completely depend on the current economic situation. You’d need to assess which areas of the stock market have been the most impacted by the downturn, and the fundamentals of each individual company. Throughout financial crashes, some stocks retain their growth potential, while others don’t survive at all.
We’ve taken a look at three cyclical stocks to highlight the different trajectories companies can experience throughout the same economic crisis – the 2020 coronavirus crash.
Expedia Group (EXPE)
Expedia is a travel company that provides booking services to holidaymakers and small business travellers. It enables individuals to compare prices and book flights, hotels and rental cars.
In the first quarter (Q1) of 2020, Expedia’s revenue was down 15% from Q1 in 2019, as bookings fell amid the coronavirus crisis. The unprecedented number of cancellations did cause a number of travel stocks to fall into liquidation, but Expedia’s management remained confident it would bounce back.
Sure enough, in April 2020, the travel firm started to see its share price rise on the back of easing lockdown restrictions.
Tiffany & Co. (TIF)
Tiffany & Co. is a prime example of a consumer discretionary stock. The maker and seller of high-end jewellery is extremely dependent on consumer spending on luxury products. However, Tiffany & Co. is also a great example of the need to do extensive research, as the bottom for each stock’s decline can be reached at different times.
Despite the initial sell-off and impact of the economic slowdown, which we can clearly see on the price chart below, shares of Tiffany & Co. quickly bounced back.
This surprised a lot of traders, who had assumed that jewellery sales would plummet – especially given the brand’s reliance on sales in the US, which became the centre of the global pandemic.
The market optimism was not based on sales or the prospect of Tiffany & Co. stores reopening, but rather the company’s upcoming merger with Louis Vuitton SE. The price per share was agreed at $135 prior to the crash, which limited the potential risk for investors – but it did also limit the growth potential once the economy started recovering.
Amazon is the world’s largest e-commerce company – selling a range of products including both consumer essentials and luxury goods. It’s widely considered a discretionary stock, as it is sensitive to the business cycle.
When we look at its performance in the 2020 coronavirus crash, we can see shares of AMZN fell in the initial March bear market.
However, in the following months, the company’s shares saw impressive gains as it adapted well to the restrictions placed on consumers. As lockdown measures increased, and many shops had to shut, Amazon was best placed to meet the increasing demand for online shopping – especially high demand for personal protective equipment (PPE).
These three examples show that every cyclical stock runs on its own timetable – emphasising the importance of technical and fundamental analysis, and remaining up to date on recent news.
Consumer Discretionary Select Sector SPDR ETF (XLY)
The Consumer Discretionary Select Sector SPDR is an exchange traded fund (ETF). Unlike trading individual company shares, ETFs enable you to take a position on the value of a group of shares from a single position. In this case, consumer discretionary stocks.
This ETF is just one of many that track cyclical stocks but it is an extremely popular option. XLY is based on a sector rotation strategy, so the weight of stocks held in the fund are reflective of which areas of the US stock market perform well in a period of recovery.
Just like the individual cyclical stocks above, the ETF experienced a sharp decline amid the global coronavirus sell-off, but started to recover in line with the US economy.
How to trade cyclical stocks
To start trading cyclical stocks, there are a few steps to take:
- Choose the stock or ETF you want to take a position on
- Create a live account with us or practise trading on a demo account
- Find the right entry and exit levels for your trade using technical analysis
- Open, monitor and close your first trade
Cyclical stocks summed up
- Cyclical industries are those that are economically sensitive
- They are profitable during periods of prosperity and inactive during downturns
- Common examples of cyclical industries include automobile manufacturers, luxury goods producers, airlines, hotels and restaurants
- Cyclical stocks are the shares of these companies – their value will rise and fall in line with company profits
- Cyclical stocks are incredibly volatile, experiencing extreme growth and declines
- Risk management is important – you should attach stops and limits, as well as diversifying your exposure
- Common indicators used to find cyclical stock opportunities are beta and EPS
- Technical and fundamental analysis will help to identify entry and exit points in the business cycle
- You can trade cyclical stocks using derivatives, such as CFDs – which means you could speculate on rising and falling share prices
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