Business cycles are an inevitable part of economics and investing. The economy fluctuates between good times when spending is up and capital is plentiful to slumps when spending is down and money is tight. In terms of investment, these business cycles can make or lose fortunes, depending on whether they are moving up or down.
These cycles can have a dramatic effect on some stocks, whereas other stocks are barely affected by them. Stocks affected by business cycles are termed cyclical stocks and those that stay stable during the cycles are called noncyclical stocks. A classic example of a cyclical stock company is a car manufacturer, whereas a classic example of a noncyclical stock company is a utility company. Understanding what cyclical and noncyclical stocks are and how they differ can help you develop better investment strategies.
When economic fortunes are rising, consumers are more apt to buy luxury-type products and services. Confidence in the economy is high and businesses have a tendency to expand during these good times. People buy more new cars, construction of new homes increases, and pricey restaurants thrive. As a consequence, these types of businesses tend to prosper in these up cycles, so they are called cyclical because of their reliance on the business cycle.
The price of cyclical stocks goes up and down with the business cycle of the economy. Examples of cyclical stocks include:
- equipment sales
- fine dining
- steel industry
Overall, 75 percent of stocks are cyclical and follow the market trend. The Standard and Poor’s 500 Index reflects this in its 10 sectors. Eight sectors are cyclical and only two, Consumer Staples and Utilities, are noncyclical.
During times when the economy slumps, consumers begin cutting out many purchases that aren’t necessary. They focus their purchases on items that they need. The worse the economy gets, the more people put off buying things like new cars and computers, and concentrate on products and services crucial to daily life, such as food, shelter, and health care.
Noncyclical stocks continue to do well even in economic downturns because what they represent is essential. They are also known as defensive stocks because they are a defense against these downturns. Examples of noncyclical stocks include:
- Household nondurable goods (like soap and toothpaste)
- Utilities (like water, gas, and electricity)
- Basic food items (like milk and bread)
In terms of investment, noncyclical stocks offer stability to your portfolio. When the economy starts to decline, it is best to move your security investments into the safety of noncyclical stocks. These stocks are generally from companies that consistently pay dividends.
The downside of noncyclical stocks is that they stay at relatively the same price even when the economy is booming. To take full advantage of a rising business cycle, you have to invest in cyclical stocks. As consumers buy more luxury items and spending becomes more plentiful, cyclical stocks reflect these gains in the economy.
As usual, risk and return are proportionate to one another. Although cyclical stocks offer more return, they are also a lot riskier. An example is Ford Motor Company. Their stock price went from a 25-year high in 1998 to a 400-percent drop in 2002, when the economy took a downturn.
As an investor in stocks, the most important thing you can do is watch the cycle of business. Where is it and where is it going? When you notice the economy is beginning to cool and move downward, move your investments into the stocks of stable companies that produce things you can’t live without. When you notice the economy is rising, move a portion of your investment capital to cyclical stocks to capitalize on the upturn. Look for sectors of cyclical stocks with the most potential for growth.