Cyclical Stocks: Are they profitable?

If the market is a person’s body, we’d all agree it’s currently not in its best shape at the moment. Whether it needs to go to the gym more frequently or eat more healthily, we could only hope it becomes better in the days to come.

Some investors suggest we look at cyclical stocks to include in our portfolios to at least ride out the recession. Does this suggestion have a warrant though? Let’s look into it.

First, let’s clarify what cyclical stocks are.

Cyclical stocks defined

It’s best to explain what cyclical stocks are through its root word -- “cycle”. The economy has four cycles: expansion, peak, recession, and recovery. Cyclical stocks are those that typically follow these cycles.

When the economy grows or expands, cyclical stocks also grow. When there’s a recession, these stocks also take a dive. In other terms, cyclical stocks are mainly affected by macroeconomic changes.

Take, for instance, the airline industry. When the economy is booming, people are travelling a lot, and airline stock prices are at an all-time high, too. But during the pandemic, when movements were halted and travel was considered a luxury, a different situation occurred.

Airline stocks are cyclical stocks, as with cars, hotels, and restaurants. They are what we call discretionary purchases. The average man can forgo buying them especially when the market is not looking good. You wouldn’t buy a car on a tight budget just because you want to own one, would you?

Compare it with utility stocks. They are considered non-cyclical or defensive stocks, because consumers need to use water and electricity regardless of the economic conditions. They are staples. We need them to survive daily, just like we need groceries even and especially during stormy market days.

Examples of cyclical stocks

What are the products or services you won’t prioritise buying in a recession? A staycation in a five-star hotel or Starbucks coffee or new Air Pods? Yes, the companies that sell these products are in the cyclical industries.

And you’ll be surprised to know there are a lot of cyclical industries out there, but here are a few of them just to give you a clearer picture.

1. Airline Industry

Yes, Boeing is a cyclical stock. Surprise, travel is considered non-essential for the average middle-class Asian. And we saw how badly impacted the industry was during the pandemic.

Today, it’s just getting back on its feet again, but the point is that airline stocks (yup, including Singapore Airlines) follow the economic cycle. People won’t travel just for the sake of travelling when the prices of their daily groceries are going up. It just won’t make sense, will it?

2. Hospitality Industry

Another “want” some might mistake as a “need” is splurging on hotels, restaurants, and other hospitality choices.

Purchasing the products and services of the hospitality industry isn’t really recommended when the economic outlook is blurry. People would want to spend on their basic needs in the cheapest way possible, e.g., home-cooked meals instead of five-course meals, a trip to the park instead of an overnight stay in a hotel.

Similar to the airline industry, hotels, restaurants, and travel companies also felt the pandemic’s impact on their profits. Some even closed off their operations because of a lack of customers.

3. Retail, Textile, Apparel Industries

Shopping can be a luxury. In economic downturns, consumers won’t prioritise buying branded workout clothes or new appliances and furniture. Women won’t even just blindly go to a salon and have some pampering treatments.

4. Automotive Industry

This is self-explanatory. Owning a vehicle isn’t cheap, especially in Singapore. People would buy a car when the economy is doing well not when it’s looking blue.

5. Semiconductor Industry

The semiconductor industry, while might not be too popular for the majority, is cyclical. This is because its products have a relatively short span.

Take, for example, graphics card manufacturer, Nvidia. This cyclical stock has shot up at a time when cryptocurrency was the talk of the town. But now that it is dropping, the stock is expected to follow the same direction.

6. Banking Industry

A bear market isn’t exactly something banks want. For one, loans and mortgages are avoided. Second, interest rates drop in periods of recession, so profits are also affected.

7. Technology Industry

Tech stocks, however famous to investors, are often classified as cyclical stocks (although there are a few exceptions). For example, consumers won’t splurge on the latest technology at a time they’re simultaneously battling against debts.

You might be surprised at the number of industries that belong in the cyclical stocks category, but the question remains: Should you include cyclical stocks in your investment portfolio?

Should you invest in cyclical stocks?

Before you decide on whether or not to include cyclical stocks in your portfolio, here are the advantages and disadvantages of buying them.

The most obvious advantage of investing in cyclical stocks is their growth potential when the economy grows. We’ve seen this before with tech stocks (Apple, Google) and entertainment stocks (Netflix, Disney) soaring at a time when consumers are confident about the economy.

Some investors don’t even care that cyclical stocks can follow the market’s direction once it drops. Their reason? Recessions don't happen that frequently. So, as long as they can get capital gains from these stocks, they’ll pour money into them. Of course, it’ll all depend on your investment risk level. Are you able to tolerate the high risks that come with these stocks or not?

But this kind of thinking would often leave some investors on the edge of their seats, especially those who don’t believe in timing the market. After all, no one knows when the economy will boom and when it will fall.

Hence, before you convince yourself to buy cyclical stocks, remember to look deeper into their fundamentals. Nothing beats owning a stock that performs well in both bear and bull markets, right?

Don’t forget that cyclical stocks are highly volatile (particularly if you compare them with defensive or noncyclical stocks), as, again, they follow the cycles of the economy, and at a time like today, we don’t know when the market is going to recover.

Perhaps the best recommendation is the good old “diversify your portfolio” advice. If you want to buy cyclical stocks, at least don’t fill your portfolio with all of them. Make room for defensive stocks and value stocks. This way, even when your cyclical stocks underperform today, you’ll have good stocks to balance out the losses.

Another option is to buy into exchange-traded funds instead. Index funds that track the S&P 500, for instance, will give you exposure to cyclical stocks, too.

Take some time to weigh your options. If you can take the risks that come with cyclical stocks, then buy them. If not, there are other choices for you to consider. But always remember, learn about it first before expecting to earn from it.

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