Investing in cyclical and defensive stocks: What's the difference?

If you want to trade stocks correctly, you need to know how the markets work and how the global economy operates as a whole, otherwise you might make bad investment decisions. One thing you need to master, though, is an understanding of both cyclical and non-cyclical stocks, so this article will tell you everything you need to know about them.

Every country experiences periods of economic expansion and contraction. These are part of what is known as the economic cycle. And while we can't control which way the market moves, we can adapt our trading decisions to its constantly changing conditions. It is key that you learn that no matter where we are in the current economic cycle, we have two types of companies. Those whose stocks are closely linked to changes in the economic cycle, and which are said to be cyclical. And those whose stocks are defensive, or non-cyclical, which are issued by companies that are not as affected by shifts in the economy.

economic cycles

Non-cyclical stocks vs. cyclical stocks

Let's quickly define what non-cyclical cyclical stocks are:

Non-cyclical stocks (also called defensive stocks) are issued by companies that are relatively unaffected by the market - they are more immune to economic fluctuations. For example, utility companies, food producers, drug manufacturers, etc., are fairly immune to recessions and expansions. This makes sense because people always need food, medicine, electricity, no matter how good or bad times are.

A cyclical stock, on the other hand, is more likely to move in the same direction as the market. If the economy is expanding, stocks tend to do well. However, when the market sinks, stock prices also sink. Cyclical stocks therefore tend to be more influenced by economic fluctuations. Because of their correlation with the economy, traders typically buy lots of stocks during recessions and then sell them when the market is booming (buy as you approach the red in the above illustration, and sell during the green period!). This is a great strategy to make the most of the economic cycle.

How do cyclical stocks move?

When the economy starts to boom, people tend to increasing their spending. A thriving economy means that companies are becoming more profitable, which leads to more jobs and better salaries. So people start spending more on things they don't need, such as huge TV screens and jacuzzis.

When people have saved enough cash, they often spend it on trips abroad, or automobiles. Some people buy clothing and new furniture or decorative items for the home. That's why all these industries - travel, sportswear, motorcycles, etc. - are said to be cyclical. They do great when the market is booming and they do poorly when the economy heads into recession mode.

Key measurement tools you should look at

There are various indicators that determine what category a stock falls into. The most important ones are:

  • The Price to Earnings Ratio (P/E) compares the price of a company's stock to its earnings. The ratio for cyclical stocks is generally lower than the ratio of non-cyclical ones. It is the most looked at ratio among traders.
  • Earnings per share (EPS) is a ratio that indicates the earnings that a stock earns. Cyclical stocks usually have a more volatile EPS because they are more closely correlated to market fluctuations.
  • Systemic risk is an indicators that analysts use to determine whether a stock is cyclical or non-cyclical. It measures the volatility of a stock in relation to the market. A high value means that the volatility of the stock is higher than the market.

Should I invest in cyclical stocks?

This is a question that you should be able to answer by yourself. But if you're not sure, remember what we said earlier regarding cyclical stocks and their correlation with market movements.

So when you buy or sell these stocks, you need to have a firm understanding of the market, including economic cycles and when the market is hitting bottom or peaking.

This is key if you want to make money. Also, don't forget the following:

It's never black or white. Sometimes stocks start to rebound during a recession or fall in an economic boom. Why? There are many other factors that contribute to stock prices.

Defensive and cyclical sectors

Vous trouverez ici des informations sur les secteurs que nous considérons comme cycliques ou défensifs.

Defensive Cyclical
Consumer products Automobile manufacturers
Utilities (gas, water, electricity) Consumer services
Mobile phone service companies Basic resources

 

Cyclical stocks tend to be closely correlated with the direction of the financial markets (see illustration below). They are therefore more volatile and offer quicker profits (and losses).

Non-cyclical (or defensive) stocks are "safe haven" stocks that are not as influenced by the economic situation. They are therefore preferred for long-term investments. Warren Buffet loved buying these.

Cyclical and defensive stocks

No matter which stock category you prefer, a portion of your investment portfolio should be reserved for stocks.

Whether you invest in defensive stocks or cyclical ones is a personal decision, and you can invest in both, as long as you understand the sector you're investing in, in relation to the market.

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