Cyclical stocks meaning
Similar to how the pedals of a bicycle rise and fall as it moves forward, the share price of specific stocks fluctuates in response to the economic cycles that a country experiences. These stocks are appropriately dubbed cyclical stocks, and in this article, we will discuss what cyclical stocks are and whether or not they are intelligent investments.
Cyclical equities are directly related to economic growth, and they closely track the economy’s progress through the expansion, peak, recession, and recovery phases. These sectors often see a multiplier effect on demand and services throughout the economy’s boom period.
The construction, steel, cement, and capital goods industries are all cyclical.
Automobile, luxury goods, hospitality, and travel industries are not directly related to economic growth, but economic growth indirectly affects their businesses. The effect is typically due to people having a more spare income, which they spend on these discretionary purchases. These are referred to as cyclical industries.
Before we discuss why and when to invest in cyclical stocks, let us examine the economic cycle’s impact on cyclical industries.
As previously stated, economic expansion results in a rise in demand for products and services that require discretionary spending. These businesses increased output by purchasing new equipment, purchasing additional machines, leasing additional storage space, and investing in other necessary utilities to fulfil demand. This results in increased revenue and profit margins for such businesses, which may be reflected in a rise in their corresponding stock price as demand for such goods and services develops at a breakneck pace as the economy expands.
Then, once the inevitable peak is reached and the economy begins to drift into recession, demand for such things dwindles. This decline in demand results from consumers cutting down on economic activity and discretionary spending, which hurts the profit margins of companies that produce these goods, resulting in a decline in their stock prices.
When the recessionary phase of the economy ends, and the expansionary phase begins, cyclical stocks become more affordable. This is a good time to begin investing in cyclical companies since they have the potential to provide enormous returns if purchased, just as the economy is ready to expand and sell just before the onset of a recession.
You ride the wave of rising stock prices and exit just before the wave reaches its zenith.
Now, let’s go over the benefits of investing in cyclical equities
Cyclical stock definition
Economic cycles have a significant impact on the stock values of cyclical companies. These equities have the potential to provide you with returns that outperform the market during an expansionary era of the economy.
And, as previously explained, when the economic cycle is at its trough, cyclical equities are frequently available at extremely attractive valuations. Therefore, purchasing such stocks at the bottom of the cycle, just before the economy begins to boom, and selling them just before another economic slowdown begins, has the potential to generate substantial returns.
Then how can you recognise cyclical stocks?
The golden rule is to invest in industries that are set for recovery following an economic downturn. Additionally, we know that industries that rely on discretionary expenditure, such as luxury shopping, airlines, autos, and others, are frequently cyclical. Within this, it is prudent to choose industries that match your risk tolerance. Large-cap corporations are typically the safest investments, whereas small-cap companies can be pretty volatile, offering the possibility for more significant profits.
Probably one of the best times for cyclical equities to see a lift is when the government announces plans to invest significant sums of money. Let me illustrate this with an example.
In 2003, the Indian government announced the Golden Quadrilateral Project, which planned to connect the country’s most innovative cities, Delhi, Kolkata, Mumbai, and Chennai, by a vast network of motorways shaped like a quadrilateral. The resources required for this endeavour would be enormous. The subsequent demand for construction material and related services, capital goods, and other items required to construct such a large project resulted in a significant increase in BHEL, L&T, Tata Power, and Crompton Greaves, all of which became multi-baggers between 2003 and 2011. However, after 2011, these equities’ prices fell, and they became laggards.
This example demonstrates that investors would have earned a profit if they had purchased such equities at the bottom of the cycle and unloaded them just before they became laggards.
Let us now discuss the downsides of cyclical stocks
Cyclical equities are highly dependent on a country’s economic foundations and, as a result, are pretty volatile. It is difficult to predict the impact of every incident on a country’s economic cycles. Consider the Covid-19 outbreak, which wreaked havoc on markets worldwide.
It’s difficult to predict which event may ignite a bull run or result in an abrupt transition from a bull run to a recession. The volatility associated with cyclical stocks can generate exponential gains during times of prosperity and exponential losses during times of crisis.
The primary risk with cyclical equities is market timing, and cyclical stocks do not match the definition of ‘buy it and forget it’ stocks. As we now know, to earn a profit, one must buy at the bottom of a cycle, just as the economy is starting to expand, and liquidate immediately after the peak, just before the downturn begins.
Volatility is a double-edged sword when it comes to cyclical stocks. Due to this volatility, you can earn substantial profits or sustain devastating losses. Timing your entrance and exit is critical for avoiding losses. While getting the timing perfect is challenging, it is critical to get the direction of the rally correct to maximise your profits while minimising your losses, if any.
As it’s never a good idea to put all your eggs in one basket, diversifying your portfolio to include both cyclical and defensive stocks is always a brilliant idea. Defensive stocks are reasonably stable and are not as highly impacted by economic cycles. Sectors such as FMCG and healthcare are not economically dependent and are therefore considered defensive equities.
To conclude, let us recap our discussion:
Cyclical stocks typically track the economy’s ups and downs.
When the recessionary era of the economy begins to subside, cyclical stocks are believed to be undervalued, as the cyclical companies they represent will experience higher demand once the economy resumes growth.
Cyclical stocks can outperform the market during expansionary stages, but they can also result in severe losses if not sold before the expansionary phase ends.
That is why it is critical to acquire cyclical equities at the bottom of a cycle and sell them just before starting an economic slump.
It is usually prudent to diversify your portfolio by including both cyclical and defensive securities.
Prices of cyclical stocks may rise during periods of economic expansion and decline during periods of economic contraction.