PhotoAlto / Getty Images Automobile companies are classic cyclical stocks. When the economy is good and people are working, car sales do well. When economic uncertainty abounds, layoffs occur, unemployment rises, and people may decide to hold off on new purchases.
How Cyclical Stocks Work
Businesses expand during good economic times. They buy new equipment, build new facilities, and have money to invest in research and development. Equipment sales, construction, real estate, and technology companies are cyclical stocks. So are companies in discretionary spending categories such as restaurants and entertainment. When the economy slows, businesses run down inventory, put off expansions, and delay purchases. Cyclical stocks in companies such as steel manufacturing and sales suffer when business slows down. This is why cyclical stocks are considered an offensive tactic in investing. You use them strategically in hopes of generating high returns as quickly as possible when the economy is good.
Cyclical vs. Noncyclical Stocks
Noncyclical stocks, or defensive stocks, are stocks that are generally based on essential items—toothpaste, soap, or food staples that people will purchase even when the economy is slow. These stocks do well in economic downturns since the demand for products and services in this category continues regardless of the economy. Noncyclical stocks represent those items and services consumers and businesses can’t do without. Utilities are another example. Consumers and businesses need water, gas, and electricity. When the economy is growing, on the other hand, these stocks tend to lag behind.
What It Means for Individual Investors
To be successful as an investor, you need a healthy balance of offensive and defensive strategies. This means your portfolio should include:
A mix of stocks, bonds, and cash Diversification by size and industry A mix of value and growth stocks
Another tactic you can try is to mix cyclical and noncyclical stocks in your portfolio to counteract changing business cycles. When investors sense the economy is approaching toothpaste times—a downturn in cyclical stock values, leading to a reliance on noncyclical stocks—cyclical stocks become less valuable.
Standard & Poors Sectors
Standard & Poors (S&P) classifies stocks into 11 sectors. Two of the sectors, consumer staples and utilities, are noncyclical stocks. The rest are cyclical, although different sectors will show higher or lower levels of volatility, thus making some moderately cyclical and some highly cyclical. Here is how S&P classifies stocks by sector:
Consumer discretionary Consumer staples Energy Financials Health Care Industrials Information technology Materials Real estate Telecommunication services Utilities
The Bottom Line
It pays to keep an eye on the business cycle to understand where it is and where it is going. For investors wanting a more conservative posture, noncyclical stocks—many of which continuously pay dividends—should make up part of your portfolio. This includes companies such as Colgate-Palmolive and the Coca-Cola Company. Understand, though, that this relative safety comes with a price. The price you pay for lower-risk, noncyclical stocks and investments is in lower returns and a longer timeline to get to your financial goals. But in times of economic turmoil, the safety factor can be a comfort for those who are nearing retirement age or who know they will need to access their funds sooner rather than later.
