The difference between cyclical and non-cyclical stocks is a question of how they perform throughout the economic cycle. Cyclical stocks tends to follow the stages of the economic cycle whereas, on the other hand, non-cyclical stocks do not.
But what is the economic cycle? How can investors identify cyclical and non-cyclical stocks? And how can they use this information to their advantage? In this article, we will answer all these questions and many more!
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What Is the Economic Cycle?
First and foremost, in order to properly explain the difference between cyclical and non-cyclical stocks, we must first explain what the economic cycle is.
The economic cycle is the term given to the various stages which an economy goes through as it grows and contracts. These four stages are expansion, peak, recession and recovery.
|Expansion: A period where the economy is growing|
|Peak: Economic growth begins to slow and hits its maximum rate|
|Recession: The economy begins to move the other way and contracts. Traditionally a recession is defined by two consecutive quarters of negative economic growth|
|Recovery: The economy hits its low point and subsequently begins to recover|
As the economy reaches its peak and starts to “overheat”, inflation begins to gather pace. At this stage, central bankers tasked with controlling inflation, begin to apply the brakes, raising interest rates and restricting the money supply. Governments too, often help things to slow things down by reducing their expenditure. If done perfectly, these actions can help control inflation without damaging the economy.
However, perfection is extremely rare and the above actions are often overdone and end up tipping the economy into a recession.
Understanding the stages of the economic cycle is important for investors. Whilst there is nothing that they can do to influence these stages, they can react to them by adjusting their investment portfolio accordingly. This is where cyclical and non-cyclical stocks come in.
What Are Cyclical Stocks?
As mentioned already, cyclical stocks tend to follow the cycle of the overall economy. In other words, cyclical stocks generally thrive when the economy is expanding and, subsequently, their share price tends to rise.
Conversely, when the economy is in contraction, cyclical stocks do not tend to perform well and this is normally reflected in their share price.
Therefore, generally speaking, cyclical stocks are desirable to investors during an economic expansion, but generally not desirable at times when the economy is contracting. This tends to be reflected by investors’ actions, many of whom rotate out of cyclical industries during times of economic turmoil.
So, how can you identify cyclical stocks?
How to Identify Cyclical Stocks
It is perhaps quite intuitive to work out which types of companies operate in cyclical industries. They tend to be companies which produce discretionary goods and services – in other words, goods and services which people consume when they can afford to do so, but which will quickly be stripped out of a budget when times get tough.
However, as well as companies which produce discretionary goods and services, cyclical companies include those whose performance can be more directly linked to the economy, an example of which we will look at in the next section.
Examples of Cyclical Stocks
Typical examples of cyclical industries include the following:
|Automobile Manufacturing: Although cars are an essential means of transport for many, a new vehicle is an example of a purchase which would likely be delayed during a recession.|
|Restaurants: When the economy is contracting, people are less likely to eat out, meaning that restaurants tend to suffer a drop in revenue.|
|Airlines: Travel plans are likely to take a backseat whilst the economy is in recession, which affects companies operating in the travel industry, such as airlines.|
|Banks: Banking is an example of an industry whose prospects are more directly tied to the health of the economy. When the economy is growing, people generally borrow more money which is good for banks, but are also better able to repay existing debt. However, when the economy is shrinking, borrowers are more likely to default on their debt, which is naturally not good for banks.|
What Are Non-Cyclical Stocks?
Whereas cyclical stocks tend to follow the trajectory of the economy, non-cyclical stocks do not. Non-cyclical stocks are also known defensive stocks, reflecting the fact that investors tend to turn to non-cyclical stocks to defend themselves from economic turmoil.
This is because - unlike cyclical stocks, which struggle when the economy is contracting – non-cyclical stocks generally perform consistently throughout all stages of the economic cycle. This explains why defensive stocks are more desirable during an economic contraction than cyclical stocks.
How to Identify Non-Cyclical Stocks
In contrast to cyclical stocks, non-cyclical stocks produce essential goods and services, goods and services which consumers need in all stages of the economic cycle.
These goods and services have inelastic demand, meaning that demand remains consistent regardless of changes in price or disposable income. Consequently, companies which produce these goods and services can rely on stable income throughout the economic cycle and it is common for non-cyclical companies to redistribute some of this reliable income through dividend payments.
Examples of Non-Cyclical Stocks
Typical examples of non-cyclical stocks include:
|Utilities: Water and energy are services that consumers cannot do without and, therefore, providers of these essential services can continue to rely on consistent demand regardless of the health of the economy.|
|Consumer Staples: This refers to a wide range of essential products bought by consumers, including goods such as food and personal hygiene products.|
|Healthcare: Here is another example of a service which remains in demand during all stages of the economic cycle. People can generally not afford to delay receiving healthcare when it is required.|
Understanding the economic cycle and the difference between cyclical and non-cyclical stocks can be very useful to investors.
When the economy is expanding, it is not uncommon for investors to weigh their portfolios more heavily with cyclical stocks, as these companies tend to benefit most from economic growth. Conversely, when a downturn occurs, or is suspected, investors often rotate out of cyclical stocks and towards defensive stocks.
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