Have you ever noticed how the economy seems to progress from growth to recession in an undulating manner? Economies expand, overheat, and then cool and contract. This circle of economic events is variously called the business cycle, economic cycle, or economic fluctuation.
The economic cycle is measured by the change in gross domestic product (GDP), which is the dollar value of all goods and services within an economy during a stated time period (usually one year or one quarter). In its simplest form, GDP is measured by either adding up everyone’s income, or adding up everyone’s expenditure (logic says these two should be about equal, but credit purchases say otherwise).
The peak of the economic cycle is reached when the most money is being spent. And when the most money is being spent, then the most goods are being purchased. Not goods that have to be purchased (for example food and household energy for heating and cooking), but goods that we all like to have, but don’t necessarily need, when we have money in our pocket. These purchases of discretionary items increases in good times and decreases in bad times, and these good and bad times are indicated by the peaks and troughs of the economic cycle.
It follows that the fortunes of companies that produce such discretionary goods and services will ebb and flow in tune with the economic cycle. The stocks of these companies are called cyclical stocks.
Cyclical Stock Sectors
Perhaps the easiest way to identify cyclical stocks is to think of the types of goods and services that you would like, but don’t need. In many cases the choice whether to purchase an item will come down to affordability. When times are a little tough, it may be that you find yourself looking in the window of a car showroom at the latest models on display. You could do with a new car, but is it a necessity? Perhaps you could have your current vehicle repaired?
So car manufacturers, and retailers, are most definitely on the list of cyclical stocks.
Then there are other spending habits. For example, we all need to eat, but do we need to have a meal out at a restaurant quite so often? So the shares of restaurant chains are examples of cyclical stocks, too.
If you think about your own spending habits, and how your expenditure might be affected by fewer working hours, lower wages, or the loss of your job, you’ll come up with a list of goods and services that you can do without, but that you like to have (as a reward for hard work and effort, perhaps?).
This list of your discretionary spending habits will bring you to a list of cyclical economic sectors. We’ve already put vehicles and restaurants on that list, and we could add other sectors such as home building, furnishings, clothing, hotels, travel, and airlines.
Why is identifying Cyclical Stocks important?
Companies only make a profit when we give them our hard earned cash in exchange for their goods and services. If we aren’t spending, profits at cyclical companies head south. Revenue decreases and earnings follow suit. If things get too bad, then cyclical companies can go bust, their stocks losing all their value.
However, when the economy is booming, then sales at cyclical companies increase dramatically and earnings rise rapidly. As earnings increase, so too do shares prices, particularly if the outlook for the economy continues to remain strong.
Because of the way that discretionary goods and services are bought, the share prices of cyclical stocks tend to move in line with the economy. Theoretically then, as an investor, therefore, being long of cyclical stocks when the economy is picking up and as it is growing will lead to profitable investment as shares prices rise. And when the economy weakens, then selling cyclical stocks will also lead to investment profit.
The Cyclical Stocks Index
As with all other sectors, there is an index that tracks the fortunes of the best known cyclical stocks. The Morgan Stanley Cyclical Indexis based upon a basket of 23 US cyclical companies. This index was started in 1978, and a look at the graph below shows how it has performed since. Note the ups and downs in a longer term upwardly trending economy.
The list of cyclical stocks upon which the Cyclical Index is based is:
Alcoa, Citigroup, Caterpillar, CSX Corp, E.I du Pont de Nemours, Deere, The Dow Chemical Company, Eaton Corporation, Ford, FedEx, Goodyear, Honeywell International, Hewlett Packard, International Paper, Johnson Controls, Masco Corp, 3M, PPG Industries, Ryder System, United Technologies, Whirlpool, United States Steel Corp.
Click to enlarge image
The Final Word
Cyclical stocks generally move in pace with the economy. By thinking about your own discretionary (cyclical) spending patterns, you’ll be able to identify companies that follow this pattern. Once you do that, you’ll see just how many companies there are that rely on the strength of the economy, and spot investment opportunities that will power your portfolio.