Cyclical Stocks: What are they and how do you invest?

Have you heard of cyclical stocks? How about defensive stocks? Understanding the difference might help you understand how an investment may perform in a given economic climate. This article explores what cyclical and defensive stocks are, their pros and cons, and how to start investing in six simple steps.

What are cyclical stocks?

Cyclical stocks are those issued by companies whose revenue tends to be sensitive to ups and downs in the economy. Classic examples are recreational travel, the latest gadgets, and luxury goods. The valuation of these kinds of stocks is sensitive because people often reduce spending on discretionary products and services when they’re watching their wallets.

For example, a travel booking company like Expedia (EXPE), may be likely to have more customers when people have cash to spare for vacations. Conversely, when money is tight, many people will forgo just-for-fun travel.
Thus, the stock of companies in cyclical sectors is more likely to grow in value in a good economy and lose value during economic downturns.

Cyclical vs. non-cyclical stocks

Unlike cyclical stocks, non-cyclical, or defensive stocks, are typically less affected by fluctuating consumer spending trends in a down economy. That’s because these sectors provide goods and services usually considered essential: think gasoline, groceries, and utilities. Even when people are cutting back, they need food and power, so defensive sector companies tend to have relatively consistent income streams.

What industries are considered cyclical?

While there are several ways to categorize industries and sectors, the Global Industry Classification Standard (GICS), developed by Morgan Stanley Capital international (MSCI) and Standard & Poor’s (S&P), is widely respected. It sorts them as follows:

Cyclical

• Consumer discretionary 
• Communication services
• Financials
• Industrials
• Information technology
• Materials 

Defensive

• Consumer staples
• Energy
• Healthcare
• Utilities

Top cyclical stocks to watch in 2022

The cyclical sectors represent a huge swath of the market, including the consumer discretionary sector. Below are the top five companies (by index weight) in the S&P Consumer Discretionary (Sector) index, as of December 31, 2021.

#1: Amazon.com, Inc. (AMZN)

Amazon, the giant online retailer, sells lots of things that people want, like the latest iPad or bestselling book, but don’t necessarily need. Of course, it also sells some must-haves.

#2: Tesla, Inc. (TSLA)

As a luxury car manufacturer, Tesla is likely to see higher sales when buyers have more disposable income and lower sales when they have less to spend.

#3: Home Depot, Inc. (HD)

While Home Depot has many essentials, it’s also a hotspot for home building and improvement. When the economy is down, people build and remodel at lower rates.

#4: NIKE, Inc. (NIKE)

Everyone needs clothing, but sporting goods and higher-end apparel tend to wind up on the chopping block when folks are watching their pennies.

#5: McDonald’s Corp. (MCD)

Even with dollar menu bargains, many families eat in when the economy is ailing. That means the fast food giant tends to sell fewer Quarter Pounders per quarter.
Interested in exploring top performers in other cyclical sectors? You may find these S&P index fact sheets helpful: information technology, industrials, materials, financials, and communications services.

Should you invest in cyclical stocks?

The answer depends on your risk profile and investment goals, and only you can decide what’s right for you. Speaking broadly, cyclical stocks can play an important role in a diversified portfolio and may offer the potential for returns in a rising economy.
That said, a stock’s sky-high price when the economy is roaring probably won’t last forever. The volatility that makes cyclical stocks so enticing also makes them riskier. You might consider balancing your portfolio with less volatile defensive stocks and other securities. And, of course, there’s always the risk that any investment could lose value.

How to invest in cyclical stocks

Before you can start investing in cyclical stocks. Start by learning to spot cyclical sectors. You might play with the GICS tool to explore sectors and industries. Of course, some cyclicals are easy to spot: designer brands, yacht manufacturers, and companies selling luxury products.

Step 1: Know your cyclicals

Start by learning to spot cyclical sectors. You might play with the GICS tool to explore sectors and industries. Of course, some cyclicals are easy to spot: designer brands, yacht manufacturers, and companies selling luxury products.

Step 2: Zero in on specific stocks

Once you know what to look for, you can research individual stocks that interest you. Another option is mutual funds or exchange-traded funds (ETFs) that invest in cyclical stocks; because funds invest in many stocks, you may get some built-in diversification by investing in funds.

Step 3: Consider your asset allocation

Take your tolerance for risk into account when deciding what percentage of your portfolio you want to invest in different types of stocks. You might devote a portion of your stock investments to cyclical stocks and balance potential risk by investing in defensive stocks as well.

Step 4: Open a brokerage account

If you don’t already have a brokerage account, you’ll need to open one to start investing. You can choose a traditional brokerage or an online brokerage. If there are specific stocks or funds in which you want to invest, you may want to check to see if the brokerages you’re considering offer them.

Step 5: Make your investments

You can invest in shares of stock or funds through your brokerage. As you consider your selections, your brokerage may offer investment advice via a human advisor, a robo-advisor, or a combination to help you decide how to balance your portfolio.

Step 6: Check your progress

As an investor, you’ll likely want to keep track of your portfolio’s performance regularly; once a month is about right for many people. Remember, cyclical stocks can feel like a bumpy ride. You’re likely to see some hills and valleys as the economy cycles through good times and leaner ones. The Stash Way, Stash’s investing philosophy, recommends investing over the long term, which can be one way to help your portfolio weather the inevitable ups and downs of the stock market.

Ready to invest in cyclical stocks?

With thorough research and a diversified portfolio, cyclical stocks could be a valuable part of your investing strategy. And understanding how they fit into the investing landscape can help you manage your investment risk for more reliable returns overall. At the end of the day, many investors find that a balance of cyclical and defensive stocks can help them reap the rewards of a booming economy while weathering downturns with less risk.