Understanding Cyclical and Non-Cyclical Stocks
Just like in war and football, investing is about developing and using tactics. It is hard to find success with only one method.
Two methods you can use for addressing the stock market are to use cyclical and non-cyclical stocks. Cyclical and non-cyclical stocks should be part of your stock-trading arsenal.
Non-cyclical stocks (defensive stocks) are stocks that are generally essential items—toothpaste, soap, or food staples that people will purchase even when the economy is slow. Cyclical stocks (offensive stocks) are other investments that follow the up and down trends of the market.
Non-Cyclical Stocks, or defensive stocks, do well in economic downturns since the demand for products and services in this category continues regardless of the economy.
Non-cyclical stocks represent those items and services consumers and businesses can't do without. If the economy suddenly takes a plunge, people still need the essential items.
An example of a non-cyclical stock is toothpaste or soap. Another could be utilities. Consumers and businesses both need clean teeth, water, gas, and electricity. When the economy is growing, these stocks tend to lag behind.
However, during economic downturns, their steady gains are necessary for investors. These are essential commodities and are considered a defensive tactic because investors will still be generating returns even in an economic trough.
Cyclical stocks follow an upward turn in the business cycle when businesses and consumers are spending money.
Automobile companies are classic cyclical stocks. When the economy is good, and people are working, car sales do well. When economic uncertainty abounds, layoffs occur, and unemployment rises, people may decide to hold off on new purchases.
Businesses expand during good economic times. They buy new equipment, build new facilities and have money to invest in research and development. Equipment sales, construction, real estate, and technology are cyclical stocks.
When the economy slows, businesses run down inventory, put off expansions, and delay purchases. Cyclical stocks such as steel manufacturing and sales suffer when business slows down.
This is why cyclical stocks are considered an offensive tactic in investing. You use them to (hopefully) generate high returns as quickly as possible when the economy is good.
You have several means to apply both offense and defense to your investing, including:
- A mix of stocks, bonds, and cash
- Diversification by size and industry
- A mix of value and growth stocks
Another tactic you can try is to mix cyclical and non-cyclical stocks in your portfolio to counteract changing business cycles.
When investors sense toothpaste times (a downturn in cyclical stock values, leading to a reliance on non-cyclical stocks) coming in the economy, cyclical stocks become less valuable.
The stock prices of cyclical and non-cyclical stocks relate to how the business cycle changes. Cyclical stocks move more dramatically, both up and down, with the cycle. Non-cyclical stocks show little movement relative to the cycle of businesses.
Standard & Poors Sectors
Standard & Poors (S&P) classify stocks into 10 sectors. Two of the sectors, Consumer Staples and Utilities, are non-cyclical stocks—the rest are cyclical. Here is how S&P classifies stocks by sector:
- Consumer Discretionary
- Consumer Staples
- Health Care
- Information Technology
- Telecommunication Services
Not all investors follow the S&P sector classifications. Don't be surprised if you visit a site and find a different set of sector identifiers. However, it may be a good idea to stick with one set of classification to avoid confusing yourself and others.
It pays to keep an eye on the business cycle, to understand where it is and where it is going. For investors wanting a more conservative posture, non-cyclical stocks, many of which continuously pay dividends, should make up part of your portfolio.
You should understand that this relative safety comes with a price. The price you pay for lower-risk, non-cyclical stocks and investments are lower returns and a longer timeline to get to your financial goals.