Cyclical stocks are a type of equity security that tends to follow the cyclical movements of the broader economy. These stocks are particularly sensitive to changes in macroeconomic factors such as interest rates, GDP growth, and consumer sentiment. In this article, we will take a closer look at what cyclical stocks are, how they work, and the risks and return potential associated with investing in them.
What are Cyclical Stocks?
Cyclical stocks are shares of companies whose financial performance tends to move in tandem with the broader economic cycle. These companies typically operate in industries that are sensitive to macroeconomic factors such as consumer spending, interest rates, and commodity prices. Some of the most common cyclical industries include:
- Automotive: companies that produce cars, trucks, and other vehicles
- Consumer Discretionary: companies that sell non-essential goods such as apparel, furniture, and entertainment
- Industrial: companies that manufacture machinery, equipment, and materials used in construction and manufacturing
- Energy: companies involved in the exploration, production, and distribution of oil and gas
- Materials: companies that produce raw materials such as metals, chemicals, and forestry products
During periods of economic expansion, cyclical stocks tend to outperform the broader market as consumers and businesses increase their spending and demand for goods and services increases. Conversely, during economic downturns, cyclical stocks tend to underperform as demand for their products and services decreases.
Examples of Cyclical Stocks
To illustrate some examples of cyclical stocks, we can take a closer look at some companies operating in cyclical industries.
- Ford Motor Company (F)
Ford is a well-known automaker and is considered a cyclical stock due to its exposure to the automotive industry. During economic expansions, consumers tend to purchase more vehicles, leading to higher sales and profits for companies like Ford. However, during economic downturns, demand for new vehicles decreases, and Ford’s revenue and profits decline.
- Caterpillar Inc. (CAT)
Caterpillar is a multinational manufacturer of heavy equipment used in construction and mining. Its stock price tends to follow the cyclical trends of the broader economy due to the sensitivity of its products to economic activity. During times of economic expansion, Caterpillar tends to see higher demand for its equipment, leading to increased revenue and profits. Conversely, during economic downturns, demand for its equipment decreases, leading to lower revenue and profits.
Risk and Return Potential of Cyclical Stocks
Investing in cyclical stocks can offer higher returns than the broader market during economic expansions, but it also comes with higher risk. Cyclical companies tend to have higher debt levels than their non-cyclical counterparts, which can make them more vulnerable to changes in interest rates.
Furthermore, cyclical stocks tend to be more volatile than the broader market, meaning their stock prices can experience larger fluctuations in response to changes in the economy. During periods of economic contraction, cyclical stocks can experience significant declines in stock prices as demand for their products and services decreases.
However, if an investor is willing to take on the higher risk associated with cyclical stocks, they can also benefit from higher returns during periods of economic expansion. Additionally, cyclical stocks tend to pay higher dividends than non-cyclical stocks due to their higher earnings during economic expansions.
Cyclical stocks are an important component of a diversified portfolio, offering higher returns during economic expansions but also coming with higher risk. Investors should carefully consider their risk tolerance and investment objectives before investing in cyclical stocks, as they can experience significant declines in value during economic downturns. By doing so, investors can make informed decisions on whether to invest in cyclical stocks as part of their overall investment strategy.