Cyclical Stocks

What Is a Cyclical Stock?

A cyclical stock is the share of a company whose business performance follows the ups and downs of the overall economy. When economic growth is strong, consumers and businesses spend more, and these companies tend to sell more and earn higher profits. When the economy slows or enters a recession, demand for their products or services usually drops, and their earnings often fall with it. Common examples come from sectors such as automobiles, airlines, hotels, retail, construction, steel, and chemicals.

How Cyclical Stocks Behave

The main driver is discretionary demand. People can delay buying a new car, booking a vacation, or building an addition to a house when money is tight. Companies that depend on this kind of spending often see their revenue move sharply in response to economic conditions. Because their costs, especially fixed costs like factories and debt payments, do not shrink as quickly as sales, profit margins can swing even more dramatically than revenue.

Stock prices of cyclical companies often move in anticipation of these changes. Investors frequently buy these shares before a recovery becomes visible in the reported numbers, and sell before a downturn appears in earnings. As a result, a cyclical company may look expensive on its current earnings at the bottom of a cycle, when profits are low, and look cheap at the top, when profits are high. This is why experienced analysts often look at normalized or multi-year earnings rather than a single year's results.

Advantages and Risks for Investors

Cyclical stocks can offer strong gains during economic expansions, and they are a common focus of investors who try to anticipate the business cycle. However, their earnings are less predictable than those of companies whose products are needed in all conditions, such as basic food or utilities, which are often called defensive stocks. Investors in cyclical companies may face large price declines during recessions, and some firms with heavy debt can struggle to survive a prolonged downturn.

Understanding where a company sits in the economic cycle, and how sensitive its revenue is to economic conditions, helps investors interpret its financial results. This is a general educational concept, and the timing of economic cycles is notoriously difficult to predict.