What are the Cyclical Stocks?
Cyclical Stocks refers to a stock or company security that mimics the macroeconomic environment of the country and provides greater returns when the economy is booming and result in losses when the economy is in bad shape. Examples of cyclical stocks include auto manufacturers, airlines, hotels, casinos, and restaurants, etc.
Advantages of Cyclical Stocks
Given below is how holding cyclical stocks tend to benefit the investor.
- Massive Growth – Cyclical stocks tend to provide massive growth to an investor when the economy is booming. The value and prices of such stocks do skyrocket as they reflect the increased confidence the consumers have placed in such companies when the economy is growing.
- Right buy before the beginning of the boom generates great returns. If an investor is able to identify the period just before the economy starts to boom, he can very well tend to amass enormous gains. Timing matters while picking cyclical stocks, and if one manages to make the right move just before the economy begins to make the uptick and thus manage to buy such stocks at the bottom of the cycle, which would go on to witness an upturn, they are sure in for a significant gain.
- Stimulus During Falling Interest Rates – When interest rates in the economy are falling, these stocks tend to have better valuations. Interest costs will be low, and earnings thus tend to increase to that extent. It is further reflected in the stock price. Therefore in environments where such interest rates are falling, cyclical stocks do get a massive boost, and hence investors tend to make a lot of money under such circumstances.
- More Volatile than Benchmark – At times, these cyclical stocks will tend to be more volatile than the benchmark indexes. It will go on to suggest that an investor who is able to time his purchase and investment in an industry which is heavily dependent on the economic strength of the country, such as the technology sector, would at times be able to generate returns above the benchmark index of the particular country.
- Reflective of Business Sentiment – One can consider cyclical stocks to be reflective of business sentiment in the economy. Thus one may be able to gauge as to where the economy is headed by very well understanding the movement of such cyclical stocks. They tend to rise during times of expansion and gradually decline during phases of recession. Thus they serve to mirror the business cycle and sentiments that prevail in the economy.
Disadvantages of Cyclical Stocks
Given below are some of the disadvantages of cyclical stocks.
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- Major Fall during Times of Recession – Since cyclical stocks tend to be reflective of the business cycles in the country, during times of recession, they do witness a significant fall in value. Investors who do not manage to sell off their stocks before the onset of economic decline will have to bear such enormous losses owing to a fall in stock prices of such stocks.
- Timing Matters – As for cyclical stocks, the timing during which you buy them does matter and should one make the mistake of having to enter into the purchase just when the economy starts to slide down from the top and thereby later sell at rock bottom at bad prices, it indeed is a recipe for disaster. Careful analysis is required before having to buy such stocks.
- High Volatility – Another major disadvantage of having to do with cyclical stocks is that they are really volatile. They tend to fluctuate a lot with the current scenario and conditions prevalent in the economy. They may, at times, go too far from the current levels and the benchmarks even heading down south way more than the levels that the current benchmark would tend to be at.
- Requires Careful Analysis – For cyclical stocks, owing to their volatile nature, careful analysis and understanding are required. It becomes imperative that one is always following the markets and is very well aware of the upcoming signs. Only when one is able to dedicate sufficient time in having to follow the market would he or she know and understand the current trends and thereby make the right decision as to when to enter and when to exit the market to take advantage of market movement and business cycles.
- Not for the long term and Passive Investors – Generally, long term investors tend to be passive and do not involve in regular active buying and selling. They do not bother to frequently follow the markets. They believe in the tenet of having to ‘Buy right and sit tight.’ Hence when the economy is in a recession and if the long term investor holds cyclical stocks, they cause significant erosion to the value of his holdings owing to the fluctuating nature of the cyclical securities.
Hence it is not advised for the long term and passive investors as they may have to wait for 7-10 years before the economy begins to pick up from the downfall. However, if they are reasonably well-diversified, that need not be the case.
Cyclical stocks owing to their fluctuating nature, tend to be very volatile and will be reflective of the business sentiment prevalent in the country. Hence because of the mirror reflection that they tend to adopt the economy, they tend to be wealth creators when the country is going on an upward spiral. They tend to increase in value, thereby reflecting the positive business and investment sentiment in the country.
However, at times of recession, they do tend to lose out enormous value due to the fall in prices and panic that would exist in the market. Timing does matter a lot when having to buy such securities, and thus careful analysis is required before making any trade decisions. Not being suited for passive investors, it would only suit such investors who would carefully follow the market and also undertake the required research and analysis.
This article has been a guide to Cyclical Stocks and its definition. Here we discuss examples of cyclical stocks along with advantages and disadvantages. You can learn more about financing from the following articles –