Over the last six months the cyclical sectors have come to life. Some well-known cyclical stocks have broken 20-year resistance levels, while others are emerging from decade long trading ranges.
In this post we highlight the types of stocks that are most sensitive to economic cycles and how you can go about evaluating them. We also compare the current economic recovery to typical economic growth phases.
- What are cyclical stocks?
- Cyclical sectors
- How cyclical stocks differ from other types of shares
- Early-stage vs. late-stage cyclical stocks
- How to invest in cyclical stocks
- Cyclical stock valuations
- Managing risks with cyclical stock investing
- How the current cycle differs from previous cycles
What are cyclical stocks?
Cyclical companies are companies that are sensitive to economic cycles. Their profits increase when the economy expands but decline when there is an economic slowdown. When the economy begins to grow at above average rates, consumer confidence, business confidence and investor confidence all increase. If unemployment rates fall and wages rise, consumers are more likely to increase discretionary spending. They are also more likely to extend their credit. The immediate beneficiaries are consumer facing business.
Businesses respond to increased consumer spending by investing to build capacity. This has a knock-on effect through most sectors of the economy. First manufacturers and construction companies see an increase in demand, and eventually commodity producers and shipping companies do too. Investor confidence improves when the economy is strong, and valuations, particularly for cyclical stocks, trade at the upper end of their range. Stock prices tend to anticipate earnings 6 to 12 months ahead, which can also make valuations appear stretched.
When a recession occurs, unemployment rises and spending falls. Cyclical companies therefore experience a drop in earnings. The effect is often amplified by the fact that companies may have over-invested during the expansionary phase, and possibly increased debt levels too. This results in share prices falling to below average valuations. The next cycle then begins. Any company that sees its profits rise and fall along with the economy is a cyclical company. They differ from other types of companies that have different dynamics. Some good cyclical stock examples include General Motors, Nike, JP Morgan, and Starbucks.
Cyclical sectors
It’s generally accepted that six of the major sectors are cyclical. These are the consumer discretionary, financial, industrial, basic material, energy, and real estate sectors. However, there are some industries and companies in these sectors that are not cyclical. There are also cyclical industries in other sectors.
- Consumer cyclicals – The consumer discretionary sector includes companies that sell goods and services to consumers but excludes non-cyclical industries. Consumer stocks are particularly sensitive to consumer spending and consumer confidence, which is in turn affected by economic indicators like employment and interest rates. This sector is also known as the consumer cyclical sector, and includes retailers, consumer goods manufacturers, and companies providing entertainment, tourism, and hospitability services.
- Financials – The financial sector, which includes banks, insurers and brokerages benefits from the expansionary phase of a cycle in several ways. Interest rates usually rise during the growth cycle, allowing banks to earn a wider margin, while also lending more. Insurance companies hold large equity portfolios, and these portfolios rise along with the stock market. Rising equity prices and increased trading volumes benefits brokers and fund managers.
- Industrials – The industrial sector includes a broad range of industries, most of which are cyclical. Examples include airlines, freight industries and most manufacturing and construction industries. They benefit from business investment, increased trade, and as more people and goods are transported.
- Basic materials and energy – The basic materials sector consists of commodity producing companies. Commodity prices are themselves cyclical and subject to long, deep cycles – or super cycles as they are known. Rising demand leads to new exploration and production, and eventually to oversupply. When commodity prices fall, some producers cease production. This eventually leads to a shortage of supply, and the cycle starts again. When the economy expands, producers sell more of whatever it is they produce, and at higher prices. The same occurs for the energy sector when activity in the manufacturing and transport industries rises. Oil and gas producers benefit from higher prices and higher volumes. The combination of higher volumes and prices can lead to very rapid earnings growth.
- Real estate – It isn’t surprising that real estate is also a cyclical industry. The property market is affected by interest rates, business confidence and consumer confidence. Longer cycles can also lead to oversupply of residential and commercial property, which amplifies the cycle.
How cyclical stocks differ from other types of shares
Non-cyclical stocks, which are also known as defensive stocks, are those that are less sensitive to the business cycle. These stocks belong to sectors like the consumer staples (also called consumer non-cyclicals), utilities, and healthcare sectors. The goods and services produced by these sectors are those that are needed, rather than wanted. Some industries within other sectors are also defensive – the aerospace and defense industry is a good example.
Counter-cyclical businesses are those that are more profitable during recessions than periods of growth. Examples would include pawn shops and some law firms. To an extent the alcohol, tobacco and gambling industries can also prove to be counter-cyclical too. However, there are very few listed companies that are truly counter- cyclical. Some growth companies are cyclical, while others are not. Growing companies that serve the consumer markets are more likely to be affected by economic downturns.
Companies that are participating in some of the megatrends shaping the future are less likely to be affected by the business cycle. Companies in the cloud computing, Software as a Service and electric vehicle industries are operating in markets that are growing regardless of the economic cycle. In many cases these companies help customers reduce costs, which mean they can do just as well during recessions. Value investing and cyclical investing are closely related. Business cycles can create deep discounts for patient value investors.
Early-stage vs. late-stage cyclical stocks
In most cases, trying to time the market isn’t a good idea. However, if you are stock picking in cyclical industries, the timing is actually important. The best cyclical stocks at any time will differ according to the stage of the business cycle, so effective cyclical investment strategies will typically rotate from one sector to another throughout the cycle.
- Early cycle – The business cycle typically begins as the economy emerges from a recession that ended the previous cycle. Often interest rates are at below average levels, and stocks prices have declined. The first companies to benefit are in the consumer cyclical, industrial, financial, and real estate sectors. These companies benefit from the low interest rates coupled with rising consumer confidence.
- Mid cycle – Businesses respond to improving sentiment by investing to increase capacity for the future. This is when revenue growth in the technology, communication, and media sectors begins to accelerate. The sectors that saw gains in the first stage continue to see growing demand, but some may begin to experience capacity constraints.
- Late cycle – Later in the cycle, the prices of commodities like metals, oil, gas and building materials have strong momentum. Commodity producers and energy companies benefit from the higher prices and rising volumes. As the cycle progresses, inflationary pressures begin to build. Central banks then begin to raise interest rates. Consumer facing businesses with pricing power can still raise prices, while those that can’t, experience a slowdown in sales and falling margins. This is when investors begin to rotate into inflation proof and defensive companies.
- Recession – Eventually cyclical companies find themselves in a situation where sales and margins are both falling as inflation and higher interest rates take their toll. Companies stop making new investments, and some may have to retrench staff. During a recession non-cyclical stocks outperform. Indexes typically correct or experience a full-blown stock market crash. Every cycle is different, but the severity of the downturn usually depends on the levels of over investment during the previous three phases.
How to invest in cyclical stocks
Investing in cyclical stocks is all about managing your expectations for a stock. Generally, when we invest in a stock we expect (or hope) the price will rise indefinitely. With cyclical stocks you should be expecting the price to both rise and fall as economic conditions change. An understanding of behavioral finance will also help you manage your expectations. Cyclical stock valuations often appear high early in the cycle as the market starts anticipating a strong economy. Similarly, when the cycle ends and stock prices decline, cyclicals may appear cheap, when they are actually value traps.
It’s also important to consider companies individually, rather than trying to apply a “one size fits all” approach. The same can also be said for each cycle because there are always different dynamics at play. Companies that are regarded as cyclical because of the industry they are in, may actually have fairly consistent earnings. An example is McDonalds which is classified as a consumer cyclical but has proved to be quite defensive in the past.
We live in a globalized world and the economic cycles of different countries are often correlated. However, individual countries can buck the global trend. Ultimately, a company’s performance will depend on the markets it operates in, not necessarily the country where it is located. Commodity producers for example, are closely tied to China’s economy, though they operate around the world.
Cyclical stock valuations
Cyclicals have very lumpy cash flows. This makes valuing a cyclical business challenging. To compensate for cyclical effects, you can use average earnings over at least 10 years. You should also use the long-term average growth rate, rather than extrapolating the current growth rate into the future.
Historical price earnings ratios for individual cyclical companies are also useful. You can use them to get a sense of what reasonable valuations look like at different stages of the cycle. For example, if a stock’s PE ratio has historically ranged between 15 and 25, that tells you that as long as the economy continues to grow, a price multiple of 25 is probably justified. But it also tell you that the multiple could easily drop to 15 during a recession, when earnings may also fall. So, if earnings fall by 50% and the PE falls from 25 to 15, the share price could fall as much as 70%.
In some cases, it may be worth holding a stock through multiple cycles. This is especially true if you manage to buy it at a historically low valuation. It’s also applicable if the company has growth attributes. In other instances, it may be worth selling when the fundamentals deteriorate. Cyclical stocks can exhibit strong trends lasting anywhere from six months to three years. It’s worth taking advantage of these trends. But, if your entry is based more on momentum than fundamental analysis, then you’ll probably want to exit the position when the price begins to fall.
Managing risks with cyclical stock investing
The risk levels for cyclical stocks vary from moderately to extremely high. The easiest way to reduce risk is to focus on the more profitable, well financed companies. At the end of every cycle there will be a number of cyclical companies either on the verge of bankruptcy, or in need of capital to remain in business. In most instances these are companies that took on too much debt when business was good. The companies that take on a lot of debt are the ones you don’t want to hold through a full cycle. Even if they do survive, your shareholding is likely to be diluted.
Investing in cyclical stocks is really a tactical asset allocation (TAA) decision. As such, you should only be making minor changes to your broader portfolio. Economic forecasts often turn out to be wrong, and you don’t want your entire portfolio to be dependent on them.
Portfolio risk and volatility can also be reduced by allocating to more defensive investment funds like factor investing funds and hedge funds. Dividend investing funds also focus on companies with more predictable cashflows and are a good way to reduce the risk of investing in cyclicals.
How the current cycle differs from previous cycles
The global economy is currently undergoing a recovery following the recession caused by the Coronavirus. For the last six months cyclical sectors have been leading the stock market, as one would expect. Year-on-year GDP figures that are published in the next few months will be showing changes from the exceptionally low base created a year ago. So, it’s likely that the cyclical sectors will continue to perform well over the next few months.
Beyond that, this cycle may be a little different from previous cycles. The recession itself was not caused by an overheated economy or rising rates. In fact, global interest rates were at historically low levels when the recession began. Bond yields are now rising, suggesting interest rates will follow.
Every business cycle is different, but this cycle is likely to be even more unique than usual. Beside the unique reason for last year’s recession, the world hasn’t enjoyed a prolonged period of above average growth for a long time. There is also a wide gap between the valuations of cyclical companies and those of growth stocks. In addition, interest rates may become relevant again, following an extended period of “cheap money”.
Conclusion: Evaluating cyclical stocks and economic cycles
Cyclical stocks are experiencing a long overdue period of outperformance. The outlook for these sectors is also looking good for the medium term. Beyond that, their performance will depend on whether or not the global economy continues to grow, and on whether interest rates rise significantly or not.
