Learn the fundamentals of cyclical stocks.TD Ameritrade shares some strategies and signals, from traders and investors, to better understand the cyclical investing concept.
A cycle is a series of events that are regularly repeated in the same order. Think back to third grade, when you learned about the water cycle—evaporation, condensation, precipitation, collection. The four seasons constitute a cycle, as do the repeating seasons of sports.
Cycles occur in the economy as well; there’s an economic cycle—booms, recessions, and points in between. Because of this, there are cyclical companies and even cyclical industries. Understanding the link between cycles and certain stock prices can help you decide how and whether to include cyclicals in your portfolio.
What are cyclical stocks? A cyclical stock is one that moves up or down as the overall economy does the same. The underlying companies tend to sell discretionary goods that consumers buy when the economy is good, and shy away from when the economy is bad. Because of this association between consumption and cycles, some refer to such shares as consumer cyclical stocks.
Cyclical stock examples include:
Why? When the economy is good, consumers are more likely to buy a new car, take a vacation, remodel their home, or get that expensive handbag. But when times are tough, discretionary expenses are often the first things to get cut.
Cyclical stocks can also be broken down into companies that produce durable and non-durable goods. Durable goods are those that have an expected lifespan of more than three years, like a car. Non-durable goods—like shoes and clothes—have an expected lifespan of less than three years.
Cyclical stocks tend to be more volatile. The market tends to overvalue them during economic booms, while undervaluing them during busts. And because they move with the business cycle, investors might consider timing their entry points. Effectively timing the business cycle can be a tricky business, but there are strategies and signals—both fundamental analysis and technical analysis—that some traders and investors use to time an entry into cyclicals.
LOOKING FOR A CYCLICAL STOCK LIST?
Many candidates can be found in the Consumer Discretionary sector. TD Ameritrade customers can set up a screener by logging in to tdameritrade.com > Research & Ideas > Stocks > Sector > Consumer Discretionary
During an economic downturn, some investors will identify cyclical industries and make a list of the strongest companies in those industries—the ones they believe are strong enough to outlast the down cycle. Then wait.
The structural changes that might happen to these businesses during downturns may take time to play out. Remember: cyclical stocks can sometimes fall further than the rest of the market. The bottoming process can take quite some time, and there may be false starts along the way.
Here’s where technical analysis might help. Some traders use moving averages to identify a potential bottom. For example, when a cyclical stock breaks above its 200-day moving average after a long period of sideways price consolidation, it might be a sign that the trend is changing. But remember, these stocks are typically not momentum stocks; they are moving in response to macroeconomic factors, and their recovery may take a while.
Because a recovery may take time (if it happens), and because false starts may occur along the way, some investors will consider a plan to divide the money to allocate to cyclical stock investing into segments and start off with a small investment. If it turns out the bottom was not yet in, they may be able to buy in at better prices, lowering the average entry point.
If, however, if the trend continues upward, you’ll need to decide how and when to make those subsequent entries in order to scale up to your target position. Have a plan—and contingency plans depending on the price movement after that initial purchase—before you start. And remember: although investing in multiple stages may have its benefits, multiple trades mean multiple transaction costs.
But no matter what strategy you decide to use, it’s important to remember that cyclical investing requires patience. Economic cycles last years, even decades. So while timing the market is always difficult, the sheer length of these cycles makes it even harder. For this reason, you should be willing to hold a stock in a cyclical industry for the long term if needed, because recessions and other forms of economic downturn can go on for years before a recovery begins.
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