Is your investment portfolio ready for the rollercoaster that the economy can sometimes impose upon it? Have you diversified across cyclical and non-cyclical stocks to ensure consistent returns? Read on to know more.
Every economy fluctuates between periods of growth and recession. This often tends to happen in a cyclical manner — expansion, peak, contraction, and trough. The GDP, unemployment rate, consumer spending, inflation level, and interest rates are some of the important indicators of which stage of the cycle an economy is in.
As an investor, it’s helpful to understand the economic cycle, as it tends to impact stocks and corporate earnings. However, not all stocks are impacted in the same way or to the same extent by fluctuations in the economy. Some are more sensitive to economic changes, while others are barely impacted. And this is where the categorisation of stocks as being either cyclical and non-cyclical arises from.
What are cyclical and non-cyclical stocks?
Stocks whose price is sensitive to changes in the economic cycle are called cyclical stocks. These stocks are closely correlated to the transitions in the economy and tend to follow economic trends.
When the economy is growing, cyclical stocks tend to go up, but when there is an economic slowdown, these stocks go down. Hence, these stocks are often volatile. Consumer durables, hospitality, and automobile stocks are examples of cyclical stocks.
Non-cyclical stocks, on the other hand, do not have a close correlation with the economic cycle, and their performance does not fluctuate in any material manner with changes in the economy.
They are also known as defensive stocks as they tend to provide consistent returns even during periods of economic slowdown and can protect your portfolio when the market is volatile. Common examples of non-cyclical stocks include stocks in the utilities, consumer staples, and healthcare sectors.
How to identify cyclical and non-cyclical stocks?
Here are some ways in which you can identify which stock is cyclical and which is non-cyclical so that you can invest according to your investment goals and strategy:
Type of goods and services
If the goods or services offered by a company are discretionary, then most often, its stock will be cyclical. That’s because when there is an economic slowdown, consumers look to cut out discretionary expenses such as shopping for clothing, furniture, and consumer durables. Expenses such as travel and leisure also get cut out.
However, the goods and services whose demand tends to remain more or less the same irrespective of economic conditions are non-cyclical. For instance, household items such as toothpaste, detergent, and soap will continue to be in demand even during a recession.
Financial metrics
There are certain financial metrics of a company that you can look at to determine whether its stock is cyclical or non-cyclical. For instance, the revenue and earnings growth of non-cyclical stocks will remain fairly stable across periods of economic expansion and contraction. Conversely, cyclical stocks will tend to have high revenue and earnings growth in periods of economic booms and low or negative growth during periods of economic downturns.
Another financial metric you can consider is beta, which measures a stock’s volatility relative to the overall stock market. The higher the beta of a stock, the more volatile it is. Cyclical stocks tend to have higher betas, while non-cyclical stocks typically have lower betas.
How to benefit from these stocks?
As an investor, you can aim to build a balanced portfolio with both cyclical and non-cyclical stocks. Cyclical stocks can provide high returns during periods of economic expansion as the demand for their products and services increases, boosting corporate earnings. But since the opposite tends to happen during an economic slowdown, non-cyclical stocks in your portfolio can act as a hedge against risk.
Non-cyclical stocks provide stable returns and are not as volatile as cyclical stocks. Hence, they tend to outperform the market when there is an economic slowdown. You can hold these stocks as a defensive investment to reduce your portfolio’s overall equity risk.
You could try to adjust your allocation depending on the economic cycle. For instance, you could invest in cyclical stocks in the early stages of economic expansion to benefit from high returns and sell them when the economy is reaching its peak. This way, you can prevent your portfolio from taking a hit when the economy enters the contraction stage.
However, it’s often difficult to predict the stages of the economic cycle in time. Hence, for long-term financial goals, it may be better to buy and hold both cyclical and non-cyclical stocks of companies with good financial fundamentals.
There are many stock market apps out there that you can use to invest in all kinds of stocks, whether cyclical or not. However, the best stock market app will also provide you with access to high-performing global stocks, along with reports, analyses, and news that will help you stay abreast of the changes happening in the economy.
Moreover, from consumer discretionary stocks like Walmart, General Motors, and Nike to consumer staples and pharma stocks like Coca-Cola, Procter & Gamble, and Pfizer, these apps will let you invest in some of the most promising stocks across industries. You can use such apps to determine the ongoing phase of the economic cycle, and adjust your portfolio accordingly.
Cyclicality and diversification
Portfolio diversification is something that every investor should think about carefully: it involves spreading out your investable capital across a variety of asset classes, industries, and geographies. Its main objective is to minimise the risk of loss by reducing your exposure to any single asset or group of assets. It can help protect your investment portfolio against unforeseen events, such as market downturns, industry-specific changes, or political upheavals.
Diversification can also help you achieve a balance between your desired level of risk and the potential rewards. For example, if you’re a risk-averse investor, you can allocate a relatively larger portion of your portfolio to non-cyclical stocks, since they’re less volatile. The converse would be true if you were an investor with a high risk appetite.
Thus, ultimately, cyclical and non-cyclical stocks have to be seen in the context of how they fit into your portfolio, plans, and personality. Remember that one of the simplest ways to build a reasonably well-diversified portfolio, one that can provide good returns across economic cycles, is by investing in both cyclical and non-cyclical stocks.
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