One key concept which all new investors should familiarise themselves with is cyclical investing.
What is cyclical investing?
Simply put, cyclical investing is a strategy that follows the stages of economic growth. It refers to the way in which both the economy and the stock market moves in cycles. A stock that closely correlates to the economic cycle is known as ‘cyclical’ whereas a stock that is somewhat unaffected by the economic cycle is known as ‘non-cyclical’.
What are the cyclical sectors?
The ASX breaks down the stock market into 11 sectors. Here are four sectors that are typically defined as cyclical:
- Basic Materials
- Consumer Cyclical
- Financial Services
- Real Estate
These sectors are generally highly sensitive to the economic cycle; each of these sectors on a fundamental basis are driven by changes in economic activity. Generally, they are closely related to consumer discretionary spending. If the economy is booming, and people are feeling more confident with their financial position, they will likely spend more money on goods and services provided by these businesses. For example, items like TVs, a new car, or a new house.
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Any example of cyclical stocks?
The ‘Basic Materials’ sector consists of companies that manufacture chemicals, building materials and paper products as well as those companies engaged in commodity exploration and extraction. When the economy is in an upwards economic cycle, the demand for building, construction and physical expansion increases. This creates a trickle-down effect that increases demand for building materials such as concrete, bricks, steel and so on.
Furthermore, the raw materials that go into manufacturing these products also experience a significant increase in demand. This cyclical boom immensely benefits companies within the Basic Materials sector as they have more demand for their products in the market and miners can capitalise on increasing commodity prices. However, when the tide turns and the economy begins to contract, these companies often suffer at an accelerated rate as economic activity slows down, and profits diminish.
In a recession, people generally tighten their wallet, and don’t spend as much on goods and services provided by cyclical companies.
What’s an example of a non-cyclical stock?
Non-cyclical sectors tend to be more defensive than cyclical sectors in nature as they’re less correlated with the economic cycle. This is due to the nature of these businesses being more correlated with day to day living. Non-cyclical businesses provide both goods and services that are either essential or aren’t impacted by discretionary spending.
Non-cyclical sectors include:
- Consumer Staples
Consider a business such as Coles, the primary business function is to supply groceries to the Australian population. During an economic downturn, people still need to head down to the shops and buy groceries.
The benefits of a stock like Coles is the defensive and non-cyclical nature of the business as it may provide some protection against volatility and poor economic conditions. However, this generally comes at the cost of a lower growth outlook and less explosive short-term returns. It is challenging for Coles to grow revenues and profits just given the nature of their business when compared to some cyclical businesses, and therefore they typically underperform during economic upswings.
Diversifying your portfolio could help you find a healthy balance
Investors may be wise to utilise diversification in their portfolios in order to gain the benefits of cyclical stocks, while also maintaining some form of downside protection. A collection of both cyclical and non-cyclical stocks may create a balance that will allow investors to realise the leveraged gains of a strong and bursting economy, while also maintaining an adequate level of defensiveness.
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Case Study: The GDX
The power and struggle of cyclical investing can be shown through the guise of the GDX index. GDX is an ETF that tracks the biggest gold mining companies in the world.
In 2008, gold entered a bull market which saw the price rise from around $800 USD per ounce to a high of $1875 USD per ounce in 2011. This allowed gold mining equities to soar during this period as they were able to immensely profit off the increase in the price of gold. The GDX index rose from around $20 per share to a high of $65 in the same time period.
In effect, the very strong performance in the gold price allowed the GDX to appreciate by 225% due to the correlation between gold mining equities and the gold price. Meanwhile the S&P 500, which represents the top 500 companies listed in the US, appreciated by 47%.
After the end of the bull run in the gold price, the GDX sustained massive losses as gold mining companies were devastated by the cyclical downturn in their business. As of today, the S&P 500 has returned 203% since 2011 while the GDX has returned -49%.
In conclusion, the case study aims to display how cyclicality seriously impacts cyclical stocks and why it is important to stay diversified across separate industries. While an investor can benefit immensely from cyclicality, when the tide turns it can get seriously messy!
Cyclical investing summed-up
When deciding on stocks to invest in, you should always consider your tolerance for risk. While cyclical stocks can boom during times of economic growth, they can also dive when the economy goes the other way. Whereas, non-cyclical stocks are generally less volatile and correlated to economic cycles. A diversified balanced approach can be utilised by investors to mitigate the risks of economic cycles. Remember that buying shares is not without risk. Always consider your options carefully before purchasing shares and seek assistance from a certified financial advisor, if necessary.
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