Definition of Cyclical Stocks
As the economy contracts or expands so does the stock market. However, stocks that are especially correlated with the business cycle, called cyclical stocks, show particular solidarity with the fortunes of the economy or a particular industry. Cyclical stocks present great opportunities for savvy investors. They become cheap as the business cycle hits a trough. However, because they will outperform other stocks when the cycle turns, investing in them can be lucrative.
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Economics
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The economics of cyclical stocks is simple. There are industries in which profits rise and fall on a cyclical basis. These fluctuations can be caused by different reasons, including stocking and destocking of inventories, fashion for certain products or materials, availability of credit, investment, overproduction, etc. As profits of companies follow cyclical patterns, so do their stocks, going up and down, reflecting the current stage of the business cycle.
Industries
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There are a wide variety of industries that can be described as having distinct business cycles: oil and gas, semi-conductors, car-manufacturing, mining, home-building, fertilizer production and many others. Their main feature is that their profits and thus stock prices follow similar rising and falling patterns over the long run. To stay competitive during the bust as well as the boom, firms in cyclical industries try to spread their investments over their cycle, saving more in good times to be able to use the money to fund necessary expenditures in bad ones.
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Cycles
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Over the long run, business cycles follow the same wavelike patterns: expansion, peak, contraction, trough and recovery. The expansion starts when the factors influencing the industry (usually demand, but could also be credit or any other factor) become favorable. The expansion can be self-enforcing if the rise of the industry has a positive effect on the driving factors (e.g., consumer demand and house prices: as house prices rise people feel richer and spend more, buying still more houses). But at a certain period of time the industry reaches its peak, followed by a contraction and subsequent trough. As the factors influencing the industry reach a floor and stay there for some time, the industry stagnates. But sooner or later, those factors improve again and better conditions cause the industry to go into a new cycle.
Opportunities
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Cyclical stocks offer great opportunities for investors who are willing to wait long enough for the cycle to move upward. On their side is the fact that stock prices go up in the long term, making stocks move not so much in cycles as in a spiral.
Risks
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Investing in cyclical stocks can be risky, however. It is sometimes difficult to tell whether stock prices have hit a trough or will continue to fall. The Japanese stock market is a good case in point, with its main index, Nikkei 225, still trading at a quarter of what it was at its peak in 1989.
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References
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