Investing in Cyclical Stocks

The economy moves in a cycle with four basic stages:

• Expansion: A period of sustained growth.
• Peak: A time of slowing growth.
• Contraction: A period of economic decline, also called a recession.
• Trough: A transitional time when the economy stops declining and begins to recover.

This cycle can have a significant impact on industries tied to economic growth. Because of that, stocks in those sectors tend to be very cyclical. Corporate profits typically rise during an expansion and contract during a recession, taking the price of cyclical stocks with them. This cyclicality contrasts with other types of stocks that tend to generate steady profits in good times or bad, making them relatively recession-proof.

We've seen cyclicality play out in many areas of the stock market during the COVID-19 pandemic. Economically sensitive stocks initially declined as the economy contracted. Most companies' stocks subsequently rebounded as the economy began to recover, but in 2022, the tides have turned once again following events such as the Federal Reserve raising interest rates.

Here’s what you should know about investing in cyclical stocks.

What is a cyclical stock?

A cyclical stock is one whose underlying business generally follows the economic cycle of expansion and recession. Cyclical businesses perform well during economic expansions but typically experience significantly declining sales and profits during recessions and other challenging economic times.

Best cyclical stocks to buy in 2022

The economy rebounded in 2021 following a deep recession in early 2020 caused by the pandemic. That helped drive many cyclical stocks higher. But cyclical stocks might still be volatile this year.

With that in mind, here are four top cyclical stocks that should still thrive in the coming year:

1. The Walt Disney Company

Entertainment giant Disney (NYSE:DIS) has some cyclicality to its business. Consumers reduce their spending on discretionary purchases such as vacations during a recession. That affects Disney’s parks and other consumer businesses.

However, demand tends to come roaring back when economic conditions improve. That has especially been the case during the past year as the pandemic had an enormous negative impact on Disney’s parks and movie businesses. However, with people becoming more comfortable enjoying experiences again, the company’s earnings have begun to recover. The trend should continue in 2022, making Disney a great cyclical stock to own this year.

2. Expedia

Expedia (NASDAQ:EXPE) operates several travel websites. The company is highly dependent on economic growth. When the economy slows -- as it did during the pandemic -- fewer people book trips using Expedia’s websites.

However, with people starting to travel again, Expedia should benefit from a surge of bookings on its websites. That should boost its income and its stock price.

3. EPR Properties

EPR Properties (NYSE:EPR) is a real estate investment trust (REIT) focused on owning experiential real estate such as movie theaters, ski resorts, eat-and-play locations, and other attractions. Demand for these experiences tends to decline during a recession. That can affect its tenants’ ability to pay rent, which happened in 2020 when the pandemic caused a steep recession.

Now that the economy is recovering, EPR’s tenants should benefit from pent-up demand for entertainment. A recovery should enable them to catch up on their rent, which should benefit the company and its shareholders.

4. Nucor

Steel producer Nucor (NYSE:NUE) tends to be highly cyclical. Demand for steel ebbs and flows with the economy. When the economy is expanding, companies use more steel to construct buildings, cars, and other industrial goods. However, demand for steel tends to decline during a recession.

With the economy rebounding following the pandemic-driven recession, demand for steel has improved over the past year. Meanwhile, recent legislation in the U.S. will boost the country’s infrastructure spending in the coming years, bolstering demand for steel. These catalysts are positive for Nucor’s stock in 2022 and beyond.

Examples of cyclical industries

It’s not practical to list every cyclical industry. However, to give you a good idea of some of the sectors prone to cyclicality, here are eight prominent and easy-to-understand examples:

• Airlines: During good economic times, both individuals and businesses tend to be more willing and able to spend money on airline tickets than during lean periods.
• Hotels: Like airlines, hotels depend on individuals and businesses spending money on travel.
• Retail: During economic contractions, people tend to spend less on discretionary retail goods. However, retailers primarily selling things that people need are not as cyclical, especially when they prioritize offering discounts. Walmart (NYSE:WMT) can be considered countercyclical since the company often increases its sales during tough times.
• Restaurants: During economic downturns, people eat at home more often than they do during prosperous times, and restaurant stocks often suffer as a result.
• Automakers: Consumers tend to hang on to their vehicles longer when recessions hit and are more inclined to buy new vehicles in prosperous times, so automaker stocks tend to be quite cyclical.
• Technology: Most (but not all) tech stocks are cyclical. Individuals and businesses are less inclined to spend money on the latest technologies and electronic devices during recessions.
• Banks: Bank stocks are cyclical. In a recession, the profitability of banks often declines. Recessions reduce demand for banking products, including mortgages, auto loans, and credit cards, and more consumers who already have loans struggle to pay their debts. In addition, interest rates usually fall before and during recessions, causing bank profit margins to contract.
• Manufacturing: In tough times, as individuals and businesses spend less on pretty much everything, companies that manufacture physical products generally experience plunging demand.

Many of the sectors mentioned above, such as automotive and retail, are consumer-facing industries and therefore part of the consumer cyclicals sector. Consumer cyclicals are consumer discretionary goods that, unlike consumer staples, aren’t strictly necessary purchases.

Consumer cyclicals are divided into two subcategories: durable and non-durable. Durable cyclicals include physical consumer goods that have long useful lives (e.g., vehicles). Non-durable cyclicals have shorter useful lives or are consumed quickly (e.g., clothing and prepared foods).

Each recession and economic downturn is different. During the COVID-19 pandemic, many of the industries mentioned above -- banking and retail, for example -- have been hurt. With the pandemic forcing people to stay at home, technology stocks have performed incredibly well. Many tech companies have either been largely unaffected or actually benefited from the circumstances.

Examples of non-cyclical industries

Some types of businesses, however, aren’t affected much by economic cycles. The stocks of these companies are non-cyclical and known as defensive stocks or recession-proof investments. They tend to perform similarly during both economic contractions and expansions.

Here are a few of the most prominent non-cyclical industries:

• Non-discretionary retail are companies selling things that people need, and they tend to be rather resilient in nature. In addition to big-box retailers such as Walmart, drugstores and grocery stores fit into this category.
• Utilities stocks tend to be highly defensive since consumers (for the most part) continue to pay their electric and water bills even during the deepest recessions.
• Real estate is another sector that is considered defensive, although the degree of defensiveness of a stock depends on the nature of the company’s properties. For example, REITs that focus on office properties or hospitals usually perform better in difficult economies than real estate trusts that invest in hotels.

That said, the nature of a recession or downturn can have surprising effects on normally defensive holdings. Many types of REITs rely on businesses being open, so real estate stocks that might otherwise have been considered defensive have generally underperformed during the COVID-19 pandemic.

Examples of cyclical and defensive stocks

To give you some concrete ideas of the types of stocks we’re talking about, here are some common cyclical and defensive stocks:

Cyclical Stocks

• JPMorgan Chase (NYSE:JPM)
• Apple (NASDAQ:AAPL)
• General Motors (NYSE:GM)
• Boeing (NYSE:BA)
• Texas Roadhouse (NASDAQ:TXRH)

Defensive Stocks

• Dominion Energy (NYSE:D)
• Costco (NASDAQ:COST)
• Equity Residential (NYSE:EQR)
• General Mills (NYSE:GIS)
• Coca-Cola (NYSE:KO)

To be clear, none of the companies on these lists are perfectly cyclical or perfectly defensive. Depending on the circumstances of a specific recession, some of the cyclical names could do relatively well. Meanwhile, the defensive stocks could see profits significantly decline. However, these are still good examples of stocks that generally behave either cyclically or defensively.

When should you buy cyclical stocks?

In a perfect world, a viable investment strategy would be to buy cyclical stocks at the start of an economic expansion and then sell them just before a recession begins. But trying to predict the timing of a future recession or expansion is a losing battle.

It's smarter to own a combination of both cyclical and defensive stocks in your portfolio. You’ll be well positioned to prosper when the economy is growing but also will have some downside protection when the economy contracts.