How to trade on cyclical stocks

Some stocks are more turbulent than others and can fluctuate with market conditions and the overall economy. In this article, we explain what cyclical stocks are and how they are different from their non-cyclical counterparts; for example, countercyclical stocks.

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What are cyclical stocks?

Cyclical stocks are essentially equities that see price fluctuations based on economic cycles (also known as business cycles). During periods of economic growth and rising inflation, cyclical stock prices tend to increase, while during periods of economic slowdown and recessions, they tend to fall.

Strong economies mean that consumers have more disposable income, which helps to increase consumer demand. This drives corporate profits and increases the dividends paid to shareholders. During recessions, consumer demand falls as individuals have less disposable income, reducing corporate profits and, therefore, share prices. This often leads to a stock market crash.

Low interest rates may benefit most (non-financial) cyclical stocks, as cheaper borrowing stimulates economic activity and investment. Conversely, high interest rates reduce consumers’ disposable income, which hits business profits and makes it more expensive for these businesses to borrow money, which may lead to a slowdown in expansion plans. This usually results in a decrease in earnings, with a negative impact on stock prices.

However, falling interest rates are associated with recessions. Central banks generally cut interest rates during slow periods of business cycles in order to stimulate economic activity. Low interest rates can be bad for banking stocks, as they cut into profit margins.

All of the above are general points. Each recession and expansion is different from the last and affects different cyclical stocks in a number of ways.

What is an example of a cyclical stock?

Tesla is an effective example of a cyclical stock. It is a manufacturer of luxury electric cars, which people buy when they expect to drive around, but also when they have plenty of money that they feel comfortable spending.

Between February and March 2020, the Covid-19 pandemic lockdowns stifled markets. The Dow Jones, S&P 500 and Nasdaq, in which Tesla shares are listed, all plummeted, as stocks were not expected to produce returns when people couldn’t go out and spend money. As a result, Tesla’s share price fell even more dramatically. The economic crisis reduced spending on luxury products and reduced travel, delaying new car purchases.

Once markets showed signs of a recovery, Tesla’s stock surged disproportionately thanks to pent-up demand and other tailwinds (such as avoidance of public transport under pandemic conditions).

[Source: CMC's Next Generation platform. Chart shows Tesla, Nasdaq, Dow Jones and S&P 500 price performances between 1 February 2020 and 1 June 2020. Please note that past performance is not indicative of future results.]

How can I identify cyclical stocks?

Cyclical assets are volatile, meaning that their prices experience fluctuations depending on market conditions. The degree of alignment with the broader economy of a stock is known as its beta value.

A beta value of one indicates perfect alignment with the broader economy. A beta value above one means the stock is more volatile than the market, suggesting that it may generate higher returns in positive economic times and lose more during downturns than the market benchmark. A beta value above one is a strong indicator that a stock is cyclical. If the stock has a beta value of below one, then it probably won’t be counted as cyclical and is considered to be less volatile than the market average.

What are some cyclical sectors and stocks?

Financial cyclical stocks

The performance of companies in the finance sector, especially consumer banking, is heavily correlated with the health of the broader economies in which they operate. When employment is high and companies are generating returns, individuals and businesses are more likely to borrow money to spend on equipment, projects and expansion. Consumer banks charge interest on this borrowing to generate their own profits.

Conversely, when economic activity is low and unemployment is rife, both people and companies tend to save money rather than borrow it, leading to a slowdown in banks’ businesses. Central banks are often known to lower interest rates in line with inflation targets, which further reduces banks’ profit margins. Additionally, rising unemployment has in the past led to an increase in defaults on loans, on which financial institutions lose money.

Investment banks and similar investment-focused financial organisations also benefit from strong economic conditions, as their investments are more likely to generate returns, so, on the whole, they perform better during periods of economic growth. However, some institutions are able to buck this trend and profit from turbulent stock market conditions.

Here’s a list of some of the major finance stocks:

Consumer cyclical stocks

Consumer cyclical stocks refer to a range of cyclical sectors that produce consumer-facing goods and discretionary services. As consumers don’t need these products to survive day-to-day, they can go without purchasing them during hard times.

Consumer cyclicals are divided into two categories: durable and non-durable. Examples of each of these are provided below, but the main distinction is that durable goods remain useful over a long period of time, whereas non-durable goods have a short active-use cycle, or get consumed rapidly.

Here’s a list of some of the major consumer stocks:

Automotive cyclical stocks

Vehicles are the best example of durable consumer cyclicals. A car is expensive but remains useful for years or even decades. There is also a great degree of variation in the pricing of different models. All these factors mean that a decision to purchase a car is carefully considered: most people will only replace their car once every few years.

Because cars have a long useful life, people will forego purchasing new ones during economic downturns. Uncertainty, especially regarding the risk of unemployment, means people are more likely to continue using their old model for longer rather than spend their savings on a new car. Conversely, when people have more disposable income, cars can seem to be a pragmatic way of spending their money, given that they will still have some resale value after several years’ use, even allowing for depreciation.

These trends apply to the automobile industry as a whole, but there will still be some new car purchases during economic downturns. Consumers may simply favour cheaper alternatives during these periods. For this reason, Ford, which specialises in cheaper, mass-produced cars, was less heavily affected than Tesla during the initial coronavirus pandemic crash, but its stock didn’t gain anywhere near as much value during the early weeks of the economic recovery. For this reason, some stocks are more volatile (or cyclical) than others, even when they form part of the same industry.

[Source: CMC's Next Generation platform. Chart shows Tesla and Ford share price performances between 1 February 2020 and 1 June 2020. Please note that past performance is not indicative of future results.]

Here’s a list of some of the major automotive stocks:

Travel and hospitality cyclical stocks

Travel, particularly airlines, as well as hospitality (such as hotels and restaurants), are typical examples of non-durable consumer cyclical industries. During economic downturns, consumers are more likely to take fewer holidays and tend to spend less on them. Even travel for business tends to reduce as companies search for ways to cut their costs, so fewer trips may be taken and spending on premium-class seats, for example, tends to fall.

The same goes for restaurant spend: when people have less disposable income, they tend to spend less on dining out and cook more meals at home.

As always, there are individual exceptions to the general rule. The coronavirus pandemic effectively closed many airlines, hotels and in-person restaurants for business, but it delivered a boon for takeaway-focused companies such as Deliveroo and DoorDash (both of which listed publicly in the aftermath of the pandemic). Similarly, fast food brands sometimes record increased sales during economic slowdowns.

Here’s a list of some of the major airline stocks:

Here’s a list of some of the major hotel stocks:

Here’s a list of some of the major fast-food stocks:

Tech cyclical stocks

Generally, tech stocks are cyclical, as consumers and businesses are less willing to spend money on new technology during recessions. However, some tech stocks do tend to perform well in recessions depending on the nature of the downturn.

For example, streaming service Netflix significantly outperformed the S&P 500 and Dow Jones stock indices throughout 2020, as it benefited from people being largely forced to stay at home and find ways to entertain themselves.

Here’s a list of some of the major tech stocks:

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What are some cyclical ETFs?

An exchange-traded fund (ETF) is an investment fund that tracks a sector or index, for example, but can be traded like a stock.

The Consumer Discretionary Select Sector SPDR Fund tracks the Consumer Discretionary Select Sector Index, which itself represents the consumer discretionary sector of the S&P 500. The fund’s largest holdings include Amazon, Tesla, Home Depot and McDonald’s. As of May 2021, the fund had more than $20bn assets under management, making it Wall Street’s largest discretionary-focused fund.

Housing is also considered a cyclical market, and the SPDR S&P Homebuilders ETF offers investors exposure to the industry through stocks such as RH, Williams-Sonoma and PulteGroup.

Investors seeking exposure to the financial sector can select the Fidelity MSCI Financials Index ETF, which invests at least 80% of assets in securities included in the MSCI USA IMI Financials Index. With holdings including Bank of America, Wells Fargo and American Express, it offers broad exposure to the consumer-focused end of the financial sector, as well as some slightly less “cyclical” finance institutions, such as Berkshire Hathaway.

What are counter-cyclical stocks?

Counter-cyclical stocks’ performances typically correlate negatively with the broader market. In other words, these stocks perform most strongly when the economy as a whole is at its weakest.

For example, Ross Stores is a discount department store chain that operates under the brand name Ross Dress for Less. Its stock price increased as the S&P 500 started falling from around April 2008, and though it plummeted in October as the financial crisis set in, the stock grew extensively in 2009, even as the wider economy languished.

[Source: CMC's Next Generation platform. Chart shows Ross Stores and S&P 500 price performance between 1 January 2007 and 31 December 2009. Please note that past performance is not indicative of future results.]

What are some counter-cyclical sectors and stocks?

Discount store stocks

Deep discount store stocks, such as Ross Stores, are a classic beneficiary of tough economic conditions. Reduced disposable income means that consumers tend to opt for the cheapest possible options for consumer staples such as clothes, groceries and other fast-moving consumer goods. As a result, these businesses tend to see footfall increase during recessions, alongside share price increases accordingly.

It is always important, however, to remember that no two slowdowns are exactly alike. Unlike during the 2008 financial crisis, Ross Stores’ share price broadly mirrored (and, on the whole, trailed) the S&P 500 over the course of the coronavirus pandemic and subsequent recovery. Its stores were forced to close under the restrictions on “non-essential” retail, which hurt its business.

[Source: CMC's Next Generation platform. Chart shows Ross Stores and S&P 500 price performance between 01 January 2020 and 28 May 2021. Please note that past performance is not indicative of future results.]

Here’s a list of some of the major discount stocks:

Automobile repair stocks

Automobile repair is a good example of an industry whose services are more required than usual during economic downturns. Consumers are less likely to buy new cars during recessions, preferring instead to keep their old car running for longer. This means they are more likely to buy parts, equipment or services to repair or maintain the older vehicle.

Automobile repair stocks that performed well in the 2008 crisis include:

Cyclical vs defensive stocks: what’s the difference?

While both cyclical and counter-cyclical stocks are highly sensitive to the condition of the broader market, defensive stocks, also known as “non-cyclical stocks”, are stocks whose performances do not generally reflect broader market conditions — either positively or negatively.

They are known as defensive stocks primarily because they are included in investor portfolios to defend against unpredictable stock market conditions, especially downturns. This is a form of portfolio diversification. Diverse portfolios will carry a blend of cyclical and non-cyclical stocks.

Typically, defensive stocks are issued by companies specialising in products that are always in demand, regardless of economic performance. One major category of defensive stocks is essential retail, such as grocers, pharmacies and large retailers like Walmart. On the whole, demand for goods such as food, medicines and toiletries remains constant throughout economic downturns. Although, as above, discount stores may be at an advantage during hard economic times, essential retail as a whole has low price elasticity compared with, for example, automobiles, so demand is relatively constant across the sector. Coca-Cola performs fairly steadily in a range of stock market conditions.

Utilities companies — for example, French nuclear power supplier EDF or telecoms providers such as Comcast — are similarly relatively unaffected by wider economic conditions. These services are in constant demand, and unless they find themselves in very dire circumstances, customers are unlikely to stop purchasing them even in tough times.

Generally, healthcare companies experience fairly steady levels of demand, although in some respects, the Covid-19 pandemic created opportunities for some healthcare-related companies out of an economic crisis. The largest healthcare firms, for example, health insurer UnitedHealth and pharmacy chain CVS Health, will on the whole be relatively unaffected by broader economic conditions.

How to trade on cyclical stocks

If you’re looking to start trading on the price movements cyclical stocks, here’s a step-by-step guide that explains how you can gain exposure via our Next Generation trading platform.

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FAQ

Are banks cyclical stocks?

Consumer banks (those that lend money to individuals, through loans, mortgages and credit cards) generally tend to be classified as cyclical stocks, as the demand for their services increases during periods of increased economic activity. Investment banks can have more complex relationships with broader economic cycles though, and some perform best when markets are weakest. Read more about financial stocks.

How are cyclical stocks affected by interest rates?

High interest rates usually reduce the performance of cyclical stocks, as they make it more expensive to borrow money, and thereby reduce capital available for investment in stocks or in company expansions. However, some financial stocks benefit from higher interest rates, as these increase their profit margins.

Are cyclical stocks growth or value?

Cyclical stocks are sensitive to changes in underlying economic conditions and are, therefore, volatile. This means they are more similar to growth stocks, which have the potential to outperform the market when it is growing. However, they are also more likely to lose value during downturns, making them riskier than value stocks (that is, non-cyclical or defensive stocks).

What are “deep cyclical” assets?

Deep cyclical assets are stocks in industry groups that are highly sensitive to economic conditions; for example, commodities companies such as steel, mining and other resources stocks, and related industries like automobiles and construction. During periods of economic downturn, these companies may not generate any profits at all, as demand for new raw materials or finished products will be incredibly low. Browse a list of economic indicators that may affect your positions.

When is a good time to rotate out of cyclicals?

A good time to rotate out of cyclical stocks tends to be at the end of a run of strong economic performance. However, it is almost impossible to know when this moment is. Some indicators to watch are a flattening yield curve and a levelling off of industrial production. Historically speaking, this stage of the economic cycle (late recovery) is a period of strong performance for energy and consumer staples stocks. Knowing which stage of an economic cycle is taking place involves trading using advanced technical analysis of stocks and prices. You should also be familiar with risk-management strategies when trading on any type of cyclical stock, as these tend to be more volatile and can result in larger losses.

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