The economy is never static. It constantly moves through various phases and cycles. For a specific period, the economy may be in the expansion phase that is marked by rapid growth and increased production. This is then typically followed by a peak in the economy, when growth attains its maximum levels. After a sustained peak, the economy typically contracts or goes into recession, when prices stagnate and markets may be oversaturated. This is then generally followed by a trough, which is the opposite of the economy’s peak.
These cycles repeat again and again and there is a marked impact on the stock market — or, more specifically, on a specific segment of the stock market that consists of cyclical stocks.
If you want to make long-term investments in the stock market, your portfolio may go through one or more such economic and market cycles. So, you need to understand what cyclical stocks are and how to incorporate them in your portfolio.
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What is a Cyclical Stock?
A type of stock that is vulnerable to macroeconomic changes in the economy is generally labelled as a cyclical stock. Since such a stock is sensitive to business and economic cycles, its price is significantly impacted by economic downturns or recessions. On the other hand, a cyclical stock also benefits from periods of economic expansion and may even outperform the market.
Also Read: What is Floating Stock?
Examples of Cyclical Stocks
Companies operating under a certain set of sectors are generally regarded to be cyclical. Here’s a closer look at such cyclical sectors.
- Travel and Hospitality
Since people are unlikely to spend during economic recessions, airlines, hotels, restaurants and other companies operating in the travel and hospitality sector are among the first to get deeply impacted during periods of recession.
- Retail
Stocks from the retail sector tend to underperform during the phases of economic recession as consumers are inclined to spend less on electronics, luxury goods and other retail goods of discretionary nature during economically turbulent times.
- Automobile
The demand for automobiles goes down significantly during economic contractions, impacting the price of stocks from this sector.
- Banking and Financial Services
Banking and financial services are negatively affected during a recession as consumers and businesses prefer not to opt for their products and services like loans, credit cards and other credit facilities.
Also Read: How Much Can You Earn From Stock Market
The Advantages of Cyclical Stocks
Now that you’ve seen the examples of cyclical stocks, let’s take a look at a few of their key advantages.
- Cyclical stocks possess high return generation potential since they often outperform the market during economic expansions.
- Cyclical stocks are a great investment strategy as they offer investors a chance to buy low during periods of economic recession and sell high when the economy moves out of recession.
- Some cyclical stocks also offer dividends, thus providing investors with an additional income.
- Many cyclical stocks belong to sectors familiar to average investors, making analysis and decision-making a lot easier.
The Limitations of Cyclical Stocks
As with any other investment option, cyclical stocks also have their limitations. Let’s look at some of the key disadvantages.
- These stocks are highly volatile and vulnerable to economic downturns, making them riskier than other types of stocks.
- Cyclical stocks may get deeply impacted by major global events like health epidemics, geopolitical tensions and changes in trade policies.
Also Read: What is Pair Trading in the Stock Market?
A Handy Guide to Investing in Cyclical Stocks
Making an investment in cyclical stocks may not be meant for every sort of investor. It is necessarily a long-term investment and, as such, requires patience and endurance. Here is a guide to investing in cyclical stocks:
- Monitor Economic Indicators
The investment in cyclical stocks is linked to the overall economic condition. Cyclical stocks perform well during economic expansion, therefore, it is important to determine the health and phase of the economy when investing in such stocks. Consider investing in cyclical stocks when the key economic indicators are negative.
- Consider Sector-Specific Factors
Certain sectors may falter despite the economy doing well due to a mismatch between the business and economic cycles. It is important to verify that the sector and the economy are in sync when you invest in a cyclical stock.
- Check the Valuation
Some cyclical stocks in India tend to be overvalued compared to others. Overvalued stocks are often the most affected during economic downturns. On the other hand, investing in undervalued or moderately valued cyclical stocks can provide a bit of protection from negative business and economic cycles.
- Remember to Diversify
Diversification is the best way to reduce the risk associated with cyclical stocks. Consider including stocks from different unrelated sectors. If you wish to diversify further, you may also add defensive stocks and different asset classes into the mix.
Conclusion
When you are creating a long-term investment strategy in the future, keep in mind the meaning of cyclical stocks, the sectors they typically belong to and their benefits and risks. This will help you make informed trading and investment decisions.
In addition to awareness about the markets, another prerequisite for trading is a demat and trading account. If you do not already have these accounts, you can rely on Bajaj Financial Securities Limited to help you open these essential accounts seamlessly and get you started on your investment journey.
