Cyclical vs. Non-Cyclical Stocks: An Overview
The terms cyclical and non-cyclical refer to how highly correlated a company's share price is to economic fluctuations. Cyclical stocks and their companies have a direct relationship to the economy, while non-cyclicals repeatedly outperform the market when economic growth slows.
Investors cannot control the cycles of the economy, but they can tailor their investing practices to its ebbs and flows. Adjusting to economic transitions requires an understanding of how industries are characterized by their relationship to the economy. It's important to know the fundamental difference between cyclical and non-cyclical companies to distinguish between sectors affected by economic changes and those that are more immune.
- Cyclical stocks are more volatile and tend to follow trends in the economy, while non-cyclical stocks outperform the market when during an economic slowdown.
- Companies of cyclical stocks sell discretionary goods and services many consumers buy when the economy is doing well, or hold off buying during slow times such as vacations.
- Non-cyclical companies sell goods household non-durable goods such as soap and toothpaste.
Cyclical stocks and their companies are those that follow the trends in the overall economy, which makes them very volatile. So when the economy grows, prices for cyclical stocks go up. Conversely, if the economy experiences a downturn, their stock prices will go down. They follow all the cycles of the economy from expansion, peak, and recession all the way to recovery.
Cyclical stocks represent companies that make and/or sell discretionary items and services many consumers buy when the economy is doing well. These include restaurants, hotel chains, airlines, furniture, high-end clothing retailers, and automobile manufacturers. These are also goods and services people tend to forgo when times are tough. When people stop or hold off buying because of a reduction in purchasing power, company revenues may start to fall. This, in turn, puts pressure on stock prices, which also start to drop. In the event of a long downturn, some of these companies may even go out of business.
For instance, people are more inclined to take their family out for an expensive meal or a good vacation when things are going well. On the other hand, if finances are depressed, they may opt to eat in and put off that trip.
Examples of cyclical industries are manufacturing, the steel industry, travel, and construction—sectors that produce things we can live without when money is tight. These are exactly the types of industries people avoid when the economy turns sour.
Investors may find opportunities in cyclical stocks hard to predict. That's because of the correlation they have to the economy. Since it's hard to predict the ups and downs of the economic cycle, it can often be tricky to guess how well a cyclical stock will do.
Non-cyclical stocks repeatedly outperform the market when economic growth slows. Non-cyclical securities are generally profitable regardless of economic trends because they produce or distribute goods and services we always need, including things like food, power, water, and gas.
The stocks of companies that produce these goods and services are also called defensive stocks because they are "defended" against the effects of economic downturn. They provide great places in which to invest when the economic outlook is sour.
For example, household non-durable goods such as toothpaste, soap, shampoo, and dish detergent may not seem like essentials, but they can't really be sacrificed. Most people don't feel they can wait until next year to lather up with soap in the shower.
Investing in non-cyclicals is a good way for investors to avoid losses when highly cyclical companies are suffering. A utility is one example of a non-cyclical company. People will always need power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically. Even though they provide safety, they are not going to skyrocket when the economy experiences growth.
Below is a chart showing the performance of a highly cyclical company, the Ford Motor Co. (blue line), and a classic non-cyclical company, Florida Public Utilities Co. (red line). This chart clearly demonstrates how each company's share price reacts to downturns in the economy.
Notice that the downturn in the economy from 2000 to 2002 drastically reduced Ford's share price, whereas the growth of Florida Public Utilities' share price hardly batted an eye at the slowdown.