Investing in Cyclical Stocks

Some stocks are quite vulnerable to recessions and economic slowdowns, while others are well positioned to maintain their profits in any economic climate. This is the basic idea behind the concept of cyclicality.

We're seeing cyclicality play out firsthand in many areas of the stock market during the COVID-19 pandemic. With all that in mind, here’s what investors should know about cyclical stocks, some examples of cyclical industries and stocks, and how you should use this concept in your investment strategy.

What is a cyclical stock?

A cyclical stock is one whose underlying business generally follows the economic cycle of expansions and recessions. Cyclical businesses perform well during economic expansions but typically see sales and profits fall significantly during recessions and other rough economic times.

Examples of cyclical industries and sectors

It’s not practical to list every cyclical industry, but to give you a good idea of some of the major types of cyclical industries, here are eight of the most prominent and easy-to-understand examples:

• Airlines: During strong economies, both individuals and businesses tend to be more willing and able to spend money on travel than during tough times.
• Hotels: Like airlines, hotels depend on individuals and businesses spending money on travel.
• Retail: During tough times, people tend to spend less on discretionary goods. Retailers that primarily sell things that people need tend to not be as cyclical, especially when they do so in a discount-oriented manner. In fact, Walmart (NYSE:WMT) actually tends to see sales increase during tough times.
• Restaurants: In poor economies, people cut back on discretionary spending and tend to eat at home more often than 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 buy fewer consumer electronic devices during recessions, and corporations are less inclined to spend money on the latest technology.
• Banks: In a recession, banks tend to take a profitability hit. Recessions create less demand for banking products, such as mortgages, auto loans, and credit cards, and more consumers who already have loans end up having trouble paying their bills. Plus, interest rates tend to fall before and during recessions, making bank profit margins contract.
• Manufacturing: In tough times, individuals and businesses buy less of pretty much everything. Most businesses that make physical products to sell tend to see demand plunge as the economic cycle turns downward.

Obviously, though, every recession and economic downturn is different. In the COVID-19 pandemic, many types of companies mentioned above -- banks and retailers, for example -- have taken a hit. However, because of the nature of the pandemic, technology stocks have performed incredibly well, as many have either been largely unaffected or have actually benefited from things like stay-at-home orders.

Example of non-cyclical industries and sectors

Some types of businesses aren’t affected much by economic cycles. These are also known as defensive stocks, as they tend to do nearly as well during rough economies as during expansions.

We already mentioned that non-discretionary retail -- companies that sell things people need -- tend to be rather defensive in nature. In addition to big-box retailers like Walmart, drugstores and grocery stores also fit into this category.

In addition to some retail, utilities stocks tend to be highly defensive, as 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 level of defensiveness depends on the nature of the company’s property focus. For example, real estate investment trusts (REITs) that focus on office properties or hospitals usually perform better in difficult economies than those that own hotels.

That said, cyclicality largely depends on the nature of the recession or downturn. Many types of REITs rely on businesses being open, so real estate has 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 a few 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 recession, some of the cyclical names could do relatively well, and some of the defensive stocks could see profits decline significantly. However, these are good examples of stocks that are generally cyclical and defensive over time.

When should you buy cyclical stocks?

In a perfect world, a good investment strategy might be to buy cyclical stocks at the start of an economic expansion and sell them just before a recession begins. Unfortunately, trying to predict the timing of a future recession (or expansion) is a losing battle.

Therefore, it’s a smart idea to own a combination of both cyclical and defensive stocks in your portfolio. That way, you’ll be well positioned to prosper when the economy is growing, but will have some downside protection when the economy takes a turn for the worse.