Consumer cyclicals, or companies in the consumer discretionary sector of the economy, make items that are not considered necessities. These stocks can be highflying in good economies, but in bad economies, their products are the first things cut out of most people’s budgets.
Consumer cyclicals have their place in an individual investor’s portfolio, but there are risks if you don’t invest at the right part of the cycle. Let’s review what these risks are and how they work.
Definition and Examples of Consumer Cyclicals
Consumer cyclicals are businesses that sell non-essential goods. The term is derived from the fact that the products are generally purchased by consumers, not businesses, and the fact that product sales (and the related stock prices) move in cycles.
This sector is also referred to as consumer discretionary. Industries in the consumer discretionary sector include automobiles; apparel; consumer services such as hotels, entertainment, and restaurants; retailing; and residential construction. Because the goods are non-essential, consumer cyclical stocks generally move in tandem with the market.
A good example of a consumer cyclical stock is Starbucks (SBUX). When the economy is doing well and money is flowing, people are willing to spend $4 to $6 for a coffee. When the economy turns and people have to be more frugal, they’re more likely to make coffee at home.
How Do Consumer Cyclicals Work
Buying consumer cyclicals is an aggressive strategy. While market timing isn’t the only part of consumer cyclical analysis, buying cyclical stocks means the investor is betting that the market will trend upward indefinitely.
When the market is going up, people have money to spend, so cyclicals do well. When it is in decline, budget constraints cause people to spend only on what they need—and cyclicals lose sales.
An example of this phenomenon is seen in the volatile returns of consumer discretionary stocks during most of 2020 and 2021. When the COVID-19 pandemic started and the market initially crashed, consumer cyclicals did poorly. You may remember stores being sold out of consumer staples such as toilet paper, but sales of discretionary goods suffered at the same time.
The demand for consumer staples in a bad economy was so high that stores either had to limit quantities or had empty shelves. Consumer cyclical companies on the other hand, suffered from restrictions on purchases, whether budget- or policy-related, and their sales went down as a result.
Once federal stimulus checks arrived and the economy started opening up, the stock market responded well, and so did consumer cyclicals. This can be confirmed with the same example above: Starbucks’ stock rose from $78 a share in early May 2020 to $110 a share in November 2021.
Unlike other stocks, the best time to buy consumer cyclicals is often when they have high valuation ratios. If a cyclical stock’s price-to-earnings (P/E) ratio is high, it could be because earnings are in a downcycle that will soon turn. Conversely, if the P/E is low, it may be because the company’s earnings are peaking in an upcycle that won’t last forever. Of course, further analysis is needed to determine the cause of a stock’s abnormally high or low P/E.
Consumer Cyclicals vs. Consumer Staples
Here’s a chart to compare aspects of these two investment sectors:
|Consumer Cyclicals||Consumer Staples|
|Represent non-essential consumer goods||Represent essential consumer goods|
|Offensive stock plays||Defensive stock plays|
|Perform better in upward-bound markets||Perform better in harder economic times|
Consumer staples stocks come from companies that produce goods that are essential for consumers—products such as toilet paper, food, soap, or clothing. Where consumer cyclicals are considered offensive stocks, consumer staples are seen as defensive for portfolios because demand for their products is likely to be consistent through market downturns.
The consumer staples sector had middle-of-the-pack returns during the bull market discussed above. Stocks in the sector generally posted increased share prices and looked overvalued after a year and a half, but they did not have quite the same returns as consumer cyclicals.
Costco Wholesale Corp. (COST) is a good example of a consumer staple stock. Costco makes most of its money from membership premiums, and in down markets, most people keep their Costco memberships to acquire discounted food, clothes, and other products. This was demonstrated in the 80% rise of Costco’s stock price from a level around $311 in early March 2020 to a closing price of about $558 in early December 2021.
Both consumer cyclical and consumer staple sectors have places in every portfolio. Effective portfolio diversification can lower volatility over time. Defensive stocks won’t go up as much as offensive holdings during up markets, but they can provide the necessary protection during down markets.
What It Means for Individual Investors
Individual investors looking to purchase consumer cyclicals can do so easily by buying individual stocks or using exchange-traded funds (ETFs).
Popular stocks such as Starbucks, Nike (NKE), Amazon (AMZN), and Tesla (TSLA) are all consumer cyclicals. Investors buying these stocks and others like them should experience good exposure to bull markets.
There are also plenty of consumer discretionary ETFs available, such as the Fidelity MSCI Consumer Discretionary Index ETF, which invests at least 80% of its assets under management in the sector for which it’s named. Yet its top five holdings are Amazon, Tesla, Home Depot (HD), Nike, and McDonald’s (MCD), all of which are classic consumer cyclicals.
Fidelity also offers industry-specific consumer cyclical ETFs, such as those invested in automotive or construction portfolios.
- Consumer cyclicals are stocks representing companies that make nonessential goods, such as luxury goods, vehicles, or entertainment products.
- Consumer cyclicals tend to move along with the market, going up in bull markets and down in bear markets.
- Consumer staples are defensive stocks that sell essential products and can hedge consumer cyclicals in a portfolio by experiencing steady demand in down markets.