What Are Cyclical Stocks?
Cyclical stocks are closely related to the concept of elastic goods. An elastic good is one whose demand changes given the state of the economy. Elastic goods are wants rather than needs. Cyclical stocks generally are connected to elastic goods, and therefore, vary in value depending on the health of the economy.
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Elasticity
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Elasticity refers to a sort of demand. An "elastic" demand is one that changes given the health of the economy as a whole. If the economy goes into a recession, then some discretionary purchases like vacations, gym memberships or new cars might be put on hold. Hence, these stocks will go down. Inelastic goods are those that need to be bought regardless of the economy. Inelastic demand is constant in that it refers to household needs that cannot be put on hold. Things like toilet paper, toothpaste, bread or diapers are needed regardless of the nation's economic health.
Stocks and Elasticity
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A cyclical stock is one issued by a firm that has a strongly elastic demand. A firm that specializes in fine jewelry is a classic example of an elastic, and hence, cyclical stock. As societies go into recession and unemployment climbs, such goods will naturally be bought less. The stock price will go down. The bigger question for the investor is when the economy will recover. If you can predict when the economy will recover, this is the time to buy more cyclical stocks at their low prices because soon, as consumption picks up, their prices will rise.
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Profiting from Cycles
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Investors who are market savvy keep a sharp eye on cyclical stocks. If faith in the economy is strong, cyclical stocks will be bought en masse while their prices are down. Of course, this will artificially raise the price. Therefore, a cyclical stock will rise based on the faith of investors in a future economic expansion. Therefore, part of the price of a cyclical stock will be based on the belief, not the fact, of an imminent improvement in the economy.
Importance
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Cyclical stocks are an excellent barometer of faith in an economy. Even if there are no objective signals of economic recovery, an increase in the price of cyclical stocks generally suggests that the investment community has faith that soon things will improve. This, in turn, can slowly boost consumer confidence. Even if you control for this "faith" factor in a cyclical stock price rise, improvement in the value of cyclical stocks suggests that consumers are willing to make discretionary purchases again. This, in turn, strongly suggests that an economic recovery is not too far off.
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