Understand Cyclical and Non-Cyclical Stocks
Protect yourself as an investor in good times or bad
As in war and football, investing is about developing and using tactics. It's hard to succeed with only one method. Two methods for addressing the stock market are to use cyclical and non-cyclical stocks.
Cyclical stocks (offensive stocks) are investments that follow the up and down trends of the market. 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 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 companies are cyclical stocks. So are companies in discretionary spending categories such as restaurants and entertainment.
When the economy slows, businesses run down inventory, put off expansions, and delay purchases. Cyclical stocks in companies 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 strategically in hopes of generating high returns as quickly as possible when the economy is good.
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 is utilities. Consumers and businesses both need water, gas, and electricity. When the economy is growing, these stocks tend to lag behind.
During economic downturns, the steady gains of non-cyclical stocks are necessary for investors. These are essential commodities and are considered a defensive tactic because investors will still generate returns, even in an economic trough.
Several means exist 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 the economy is approaching toothpaste times—a downturn in cyclical stock values, leading to a reliance on non-cyclical stocks—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) classifies stocks into 11 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
- Real Estate
- 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.
The Bottom Line
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. This includes companies such as Colgate-Palmolive and Coca-Cola Co.
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. But in times of economic turmoil, such as the state created by the COVID-19 pandemic, the safety factor can be a comfort for those who are nearing retirement age or who know they will need to access their funds for a specific purpose such as buying a house or paying for a college education.