Cyclical stocks tend to follow the various stages of the economic cycle. When the economy is expanding, unemployment is low, and spending is high, cyclical stocks tend to do well. On the other hand, when the economy slows and slips into a recession, these stocks tend to suffer. Industries that are considered cyclical are restaurants, airlines, and automobile manufacturers.

Rocket Companies (RKT 0.58%), which went public last year and is the largest mortgage originator in the U.S., is cyclical but follows a different schedule than your standard cyclical stock. Let's take a look at how Rocket works and if it's the cyclical stock for you.

How Rocket's business works

Rocket is in the business of originating mortgage loans to people looking to buy a home or refinance an existing home loan. It does have other business segments like auto lending, but the majority of its business revolves around home mortgages.

However, unlike banks that originate home loans and then hold them on their balance sheets and collect monthly mortgage payments, Rocket sells almost all of the loans it originates into the secondary market. For each sale it collects a fee, so the business is very heavily reliant on origination volume, which can be heavily influenced by interest rates, the primary determinant of Rocket's cycle.

Picture of home on big grassy lawn.

Image source: Getty Images.

The Federal Reserve's benchmark federal funds rate, which sets the overnight borrowing rate for banks, influences all other rates. This includes the yield on the 10-year Treasury note, which mortgage rates directly move with.

Unlike traditional cyclical stocks, rates -- and therefore Rocket's business -- can pick up at different times of the cycle that you may not expect. That's because home sales and refinancings tend to pick up when interest rates are lower and when people can get cheaper monthly payments on their loans. When rates rise, fewer people are buying homes because those monthly payments are more expensive. And remember, Rocket doesn't hold loans on its balance sheet, so it does not benefit from higher monthly interest payments like a bank would.

This is where things can get tricky. If the economy is expanding and starts to run too hot, inflation concerns can come into play and then the Fed will increase rates. This is bad for Rocket's business because it increases monthly mortgage payments. Vice versa, when the economy looks like it is about to enter a recession, the Fed usually lowers rates to try to boost the economy by making lending cheaper. This benefits Rocket's business by lowering monthly mortgage payments, sending more people into the market and increasing originations.

So for Rocket, instead of trying to determine when the economy will expand and slow, it's more important to watch where rates are and how they might trend to see where the company is in its cycle.

Where are we in the cycle?

Prior to the pandemic, rates had been trending downward, with the fed funds rate just above 1.5%, which is closer to the high end of where it has been since the Great Recession. Once the pandemic hit, the Fed, sensing an abrupt recession, quickly lowered the fed funds rate to zero, sending the 10-year yield and therefore mortgage rates spiraling to all-time lows (long-term rates move on expectations of inflation and future rate hikes).

This caused a boom in the mortgage business, largely because people rushed to refinance, and Rocket took advantage. Closed loan origination volume at the company rose roughly 120% in 2020; total revenue more than tripled; and Rocket generated nearly $9.4 billion in profit, up 948% from 2019. Note that most traditional cyclical stocks like airlines and restaurants got killed in 2020 because of government-mandated lockdowns and the fact that people were staying home in general due to the pandemic. But because rates were historically low, the mortgage business flourished. Several mortgage companies including Rocket took advantage of the boom times and went public. 

Unfortunately, many believe the mortgage market may have peaked in 2020. The yield on the 10-year Treasury has risen sharply in 2021 as the federal government pumped more than $2.8 trillion into the economy through two different stimulus bills. With gross domestic product expected to reach levels this year not seen since 1984, economists are penciling in a rate hike in 2024, although some speculate it might happen earlier. So while there may be a few years left of the low-rate environment, rate hikes are likely coming, meaning Rocket is likely headed toward the down part of its cycle.

Rocket could still surprise us

One thing to understand is that people don't stop buying homes when rates rise. Sure, not as many buyers will be in the market, but there are still plenty of sales happening. However, refinancings do slow significantly because homeowners aren't going to refinance to a higher mortgage rate.

This is problematic for Rocket because the company is more reliant on refinancings than purchase mortgages. Susquehanna analyst Jack Micenko said last year that while Rocket controlled 9% to 11% of the refinancing mortgage market between 2018 and 2020, its share of the purchase mortgage market was in the 2% to 3% range.

Rocket's plan is to achieve 25% market share of the mortgage market by 2030, and leverage new and existing partnerships to boost its success in the purchase market, so it is better positioned for when rates rise. There is some evidence that this plan is starting to work. On its most recent earnings call, Rocket said it expects closed loan origination volume in the first quarter of this year, which just ended, to drop by 5% from the fourth quarter of 2020. That would be a very strong performance, considering what a record year 2020 was and how much the yield on the 10-year Treasury note increased in the first quarter.

While the mortgage market is extremely tied to interest rates, it's also very fragmented, and Rocket is the biggest player in my mind. If there is a mortgage originator that can grab a more dominant market share, I believe it would be Rocket. That is why I do see upside for the stock, currently trading below $23 per share. But continue to watch origination volume closely as the yield on the 10-year continues to rise.