What is a cyclical stock? Definition and examples

Have you ever noticed that some companies tend to do well when the economy is booming, but struggle when things slow down? These are known as cyclical stocks. They move with the economy, just like a cycle, which explains the name.

In this article, we’ll take a closer look at what cyclical stocks mean, how they work, and why they can be both appealing and risky for investors.

• Table of contents

• What is cyclical stock?
• How do cyclical stocks work?
• Example of cyclical stocks
• Interdependence of cyclical stocks and the business cycle
• Advantages of cyclical shares
• Limitations of cyclical securities
• Cyclical vs. non-cyclical stocks
• Taxation on cyclical stocks
• Suitability of cyclical stocks
• Different cycles and their stocks
• When to invest in cyclical shares

What is cyclical stock?

A cyclical stock is a share of a company whose performance is directly linked to how the economy is doing. When the economy grows, people spend more, and these companies earn more profits. But when the economy slows down, their sales drop, and so does their stock price.

In summary:

• Cyclical stocks rise in good times.
• They fall during slowdowns or recessions.
• They are tied to industries that depend on consumer spending.

How do cyclical stocks work?

As the term suggests, such stocks move in cycles. They go up when people are earning and spending more and go down when spending falls. These companies usually sell non-essential items or services. Think of things people can live without during tough times.

Common sectors that have cyclical stocks:

• Automobiles: People delay buying new cars in bad times.
• Real estate: Fewer home purchases during slowdowns.
• Travel and tourism: Vacations are often cancelled in tough times.
• Luxury goods and consumer durables: Such as electronics, furniture, etc.

When the economy recovers, demand picks up, and these businesses bounce back strongly.

Read Also: Growth Stocks: Meaning, Features and Investment Strategies

Example of cyclical stocks

Let’s look at some hypothetical examples to understand cyclical stocks better:

• A company in the automobile sector sees a sharp increase in vehicle sales when the economy is doing well. But during tough times, customers delay new purchases, and sales fall.
  A construction firm does well when the government and private sector invest in infrastructure. During economic slowdowns, projects may get delayed, affecting revenues.
• An airline company may earn high profits when people are travelling more, but face losses when travel demand drops due to weak consumer sentiment.

These examples of cyclical stocks show how their performance depends on the overall health of the economy.

Interdependence of cyclical stocks and the business cycle

Cyclical stocks closely follow the business cycle, which has four main phases:

• Expansion: The economy grows, people spend more, businesses earn more, and cyclical stocks begin to rise in value.
• Peak: The economy is at its highest point, pace of growth slows, and stock prices may stop rising or even start to decline.
• Contraction: A slowdown begins, spending reduces, company earnings drop, and cyclical stock prices usually fall.
• Trough: This is the bottom of the cycle. Economic activity is low, but this is often the best time to invest in cyclical shares at lower prices.

Smart investors try to buy cyclical shares during the trough or early expansion phase and sell them during the peak, locking in gains before the next contraction starts. Understanding this timing is key to making the most of these investments.

Read Also: Penny Stocks: Meaning, Features and how to invest

Advantages of cyclical shares

Investing in cyclical shares can potentially be rewarding if you time it right. These stocks can offer growth opportunities when the economy is on the rise. Some key advantages of cyclical shares include:

• Potential for returns during growth phases: When the economy improves, sales and profits of cyclical companies may rise, leading to price appreciation in their stocks.
• Suitable for long-term investors who can handle ups and downs: Those who stay invested over multiple cycles can benefit from the long-term growth potential these companies offer.
• Opportunity to buy low and sell high: Prices often drop during downturns and can rise during booms, creating a potential profit opportunity.
• Reflect broader economic trends and are easy to track: Because they typically move with the economy, investors can use economic indicators to make informed decisions on when to enter or exit.

Cyclical shares can be suitable for those who are patient, informed and seek to potentially capitalise on market movements.

Limitations of cyclical securities

Of course, cyclical stocks also carry their own set of risks, such as the following:

• Sharp falls during downturns.
• Volatile in nature; prices can swing a lot.
• Require timing and economic awareness.
• Not suitable for conservative or short-term investors.

So, it's important to understand your own risk level before investing.

Cyclical vs. non-cyclical stocks

Let’s compare the two to understand better:

Non-cyclical stocks, also called defensive stocks, remain steady in all economic conditions. Examples include essential goods, healthcare, and utilities.

Taxation on cyclical stocks

Whether a stock is cyclical or not, taxes depend on how long you hold it. The taxation on cyclical stocks is the same as for any equity shares in India:

• Short-term capital gains (STCG): If you sell the stock within 1 year, gains are taxed at 20%.
• Long-term capital gains (LTCG): If held for more than 1 year, gains above Rs. 1.25 lakh are taxed at 12.5%.

Suitability of cyclical stocks

Cyclical stocks may be suitable for:

• Investors with higher risk tolerance.
• People who can stay invested long-term.
• Those who can watch economic indicators and make informed decisions.
• Investors looking for value buys during market lows.

They may not be suitable for people who want a relatively stable avenue, such as low or moderate risk investors or retirees.

Read Also: Blue Chip Stocks: Meaning, Benefits, and Key Reasons to Invest

Different cycles and their stocks

While all cyclical stocks move with the economy, each sector reacts to different levers. Here's a view of what may drive each sector:

• Automobile cycle
  Influenced by interest rates, fuel prices, and consumer sentiment. When borrowing is cheap and incomes are rising, car and bike sales tend to go up.
• Real estate cycle
  Moves with home loan rates, urban demand, and regulatory environment. A fall in interest rate or a stable job market can spur home purchases.
• Travel and tourism cycle
  Depends on discretionary income, fuel costs, and global stability. When people feel financially secure, they spend more on travel.
• Capital goods cycle
  Tied to industrial growth, corporate capex, and government infrastructure push. Typically picks up in the mid to late phase of an economic expansion.

When to invest in cyclical shares

A suitable time to invest in cyclical stocks may be:

• Near the bottom of the economic cycle (when things look dull).
• When interest rates are low, and recovery is expected.
• After a market crash, when stocks are undervalued compared to their intrinsic value.

Conclusion

Cyclical stocks can be potentially profitable in the long term, but they come with their own ups and downs. By understanding what is a cyclical stock, how cyclical stocks work, and when to invest, you can make informed decisions.

Remember, cyclical stocks are not for everyone. But if you’re willing to stay patient, cyclical shares can be rewarding. Keep an eye on the economy, stay informed, and always invest with a clear goal in mind.

FAQs

Are banking stocks cyclical?

Yes, banking stocks can be cyclical because their performance often depends on interest rates and economic growth.

When should you buy cyclical stock?

It may be suitable to buy cyclical stocks when the economy is reaching its low point and has the potential to recover soon. Prices are usually low at that time.

When is the best time to sell cyclical stocks?

It is suitable to sell during the peak of the economic cycle, before prices start to dip again.

What affects cyclical stock?

Economic factors like interest rates, consumer spending, inflation, and government policies can all impact cyclical stock performance.

Are cyclical stocks volatile?

Yes, cyclical stocks can be quite volatile because they rise and fall with the economic cycle.

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