If you are a seasoned investor you must have observed trends in the sectors/stocks. Some stocks trend in a particular period while say inactive otherwise.
Well, if you are part of investing you are indirectly part of the financial industry, assuming that you are prepared before investing, you must be aware of the business cycles. The combination of knowledge of business cycles and your technical/fundamental/qualitative foundation helps you make informed decisions for your investments.
Even if you are sound fundamentally but have no understanding of such cycles making the right investments seems remote because as an investor you are not able to gauge the right time. An investor needs to understand the difference between cyclical and non-cyclical industries.
In this blog article, let us discuss understanding such industries and explore your opportunities with their performances.
All about cyclical Industries
An organization or industry which tends to grow during trending markets in a business cycle and trembles down during economic downturns falls in the category of ‘cyclical’. Such cyclical organizations are usually involved in providing peripheral products and services which are consumed slightly and during times of economic decline, it is considered a luxury for some. A non-cyclical sector focuses on essential items and services (FMCG) that helps maintain the demand-supply fluctuation in the market.
All about the business cycle
Business cycles are important to understand from an investor perspective as it provides an idea of opening opportunities in the future. To get an idea of such opportunities we need to understand the business of such industries, and hence its the business cycle. Note that the Business cycle is a phase and it lasts for months and sometimes for years.
For every business cycle there are ideally four stages:
Expansion: After entering the market, the business starts expanding, the business cycle is in the expansion phase. During this stage, the economy is in favour of the business, and it grows too. With this positive sign, efficiency increases, there is a fall in unemployment numbers and spending is at the peak. Consumers tend to spend and can afford the non-essentials, which causes the stock market to expand further and act as a booster!
Peak: Economic growth stops when the expansion stage reaches the apex. At this juncture, employment rates and prices skyrocket. The economy is saturated and can’t continue to withstand expansion. At this point, economic decline sets in.
Contraction: The economy shows signs of contraction. There is fear and uncertainty in the stock market because of declining demand and production, a rise in the unemployment rate, wage cuts starts. This generates pressure on the nation’s gross domestic product (GDP), which trembles from its starting point in the business cycle. In short, the economy is in a depression.
Trough: The economy touches its lowest point leading to negativities in the market everywhere. Supply, demand, unemployment, and wages witness their worst numbers ever. But as there is light at the end of the tunnel, there is a new business cycle that starts at the end of the trough. This cycle started based on motivating factors like change in trend, innovation etc. Thereafter, the recovery stage begins.
You might be thinking that, if there are such moody stocks we can also benefit from stocks that are anti-moody!
Meaning benefiting from opportunities when investing with cyclic and non-cyclic stocks. Such stocks are called defensive stocks in the market. There are some sectors that are directly linked to economic growth. Cement, construction, steel, capital goods are all some of the classic examples of cyclical stocks.
So now we know the sectors and their natures, do you know the right time to grab the opportunity and invest?
Remember, almost all companies in this category are prepared with a full proof plan well ahead for such market fluctuations for the business cycle to such short sustain economic volatility. During such declines, industries in these categories generally lower their expenses. Such practices include reducing the workforce, purchasing limited supplies, and making smaller capital investments.
They also take an edge off with production levels to cater for the lower demand and decreased purchasing power. These essential changes support such cyclical companies to sustain in business despite drastic unexpected changes to the economy. In times of economic growth, a cyclical business generally does the opposite.
Hiring, production and purchasing are heavily focused on expanding purposes.
These companies also look pay attention to employee welfare and raise salaries to attract top employees in the industry and encourage increased production.
Know that we have understood what a cyclical market looks like, we know that in such a cyclical market, there is a higher possibility that the value of a publicly-traded company might fluctuate significantly over the course of the business cycle.
Even their stock is volatile like the cyclical industries, cyclical stock values are directly proportional to the state of the economy and the current stage of the existing business cycle. When economic growth slows and consumers stop buying the products and services that these businesses sell, and hence the revenue drop. As a result, their stock prices fall. In the case of an extended contraction stage or a lengthy depression, these cyclical companies may go out of business.
During the expansion or correction, usually, the value of cyclical stocks rebounds. As demand, hiring and production increase so does the corporate revenue and stock value. In most cases, cyclical stocks experience exponential growth, which may make them particularly attractive to investors. A typical example of this is the pharma and health care sector during the and post-pandemic.
Trading cyclical stocks might seem profit-making, but it isn’t always the way. These business cycle shifts are comparatively slow to manifest, even experienced investors fail to predict economic trends accurately. Thereby, cyclical stocks might seem less attractive for a portfolio by naïve/inexperienced investors or those with more limited portfolios. Accordingly, if you think about the defensive stocks, they aren’t as closely correlated to anything in the markets.
They usually react to the market sentiments and to the companies that produce essential goods, their value doesn’t fluctuate as much.
Therefore, these stocks often enjoy a strong performance even when the economy contracts. These stocks slightly have a higher hand on being profitable, even during an economic downturn. During a depression or recession, investing in non-cyclical stocks can be a sound business decision, as they’re less likely to experience a significant decrease in value.
However, non-cyclical stock value is less likely to achieve explosive growth during the expansion phase, which can make them less desirable to investors seeking more substantial results.
When the government declares external stimulus its game-changing for economy. The stimulus comes in various factors.
Heavy Investments in infrastructure, health care, education, tourism facilities acts as a driving factor for the growth of the economy. To summarize, It would be better to say that, cyclical stocks are largely dependent on economic variations. When the combination of investment and growth is in their favour, these cyclical stocks can give humongous returns in a very short period.
That is the reason cyclical stocks are critical for your portfolio as water for the human body. And hence timing is everything.
Not timing the market but the timing the purchase of cyclical stocks matters!