How do you capitalize on the business cycle by investing?
There are several options, but one is to invest in cyclical and cyclical consumer goods stocks. The performance of these companies is closely linked to the development of the economy.
If consumers can spend extra cash on non-essential items, they should do well. But when consumer budgets get tight, these companies are also among the first to be hit.
In this article, we’re going to look at the pros and cons of cyclical and cyclical consumer stocks. We also explain the best ways to invest in them. Here’s what you need to know.
Understand the economic cycle
Cyclical and cyclical consumer goods stocks closely follow the business cycle. Therefore, it is important to understand what this cycle is and how it works before we talk about these two groups of stocks.
The economic cycle is often described as “boom and bust” phases, however the “booms” and “busts” can be very subtle. There are four main segments of the economic cycle as shown below. Note that while each cycle goes through the following phases, no phase is necessarily considered “first”.
Troughs are often referred to as recessions. This is when the economy has collapsed, people are laid off, consumers are not spending that much, and some stores close. Times can be difficult during a recession.
extension means the economy is coming out of a recession. Things are looking up. People are being hired again, businesses are expanding and investing in capital expenditures (ie investments), and consumers are starting to spend more.
At some point the expansion will overheat and the business cycle will become his summit. At its peak, consumers are spending as much as possible, employment has peaked, and prices have risen due to demand.
At its peak, the high prices will lead consumers to withdraw their spending. When spending slows down, companies lower prices and squeeze profit margins. In return, companies are looking for ways to cut costs, which often leads to layoffs. Now the economy is in contraction. If it continues, the economy will enter a new recession (i.e. bottom out). And with that the cycle begins again.
What are cyclical and cyclical consumer stocks?
The ability of consumers to spend on non-essential products is known as discretionary income. This should not be confused with the disposable income used to calculate payments for an income-based student loan amortization schedule. In this case we are referring to the income a consumer is left with after covering all essentials like food, rent, electricity, and local travel.
Cyclical stocks follow the business cycle described above because they produce non-essential (or unsustainable) products. As the economy expands and consumers have disposable incomes, they are buying non-essential products. But once the economy starts to decline, consumers will spend less on these items, and maybe even leave them out altogether.
Some examples of cyclical values are:
The above sectors generally do well during a growing economy (i.e. expansion). However, as it cools, consumer spending will shift to less cyclical sectors. This is known as sector rotation.
When the economy emerges from a recession, one sector that does well is the financial sector, including banks, brokers, and insurance companies. At some point, non-essential things will also begin to perform well and will drive the expansion phase.
While cyclical stocks can do well during expansion phases, non-cyclical stocks are safer choices during economic downturns because their sources of income are more “recession-proof”.
The less economically sensitive sectors include:
These sectors can have other names such as “Consumer Staples” or “Defensive” sectors.
Examples of cyclical stocks
Let’s look at some examples to understand what cyclical and cyclical consumer goods are. Here are a few well-known cyclical stocks:
- Amazon (AMZN) – Internet direct marketing retail
- Tesla (TSLA) – Automobiles
- Home Depot (HD) – specialist retailers
- McDonald’s (MCD) – Hotels, Restaurants, and Leisure
- Marriott (MAR) – Hotels, Restaurants, and Leisure
- Starbucks (SBUX) – Hotels, Restaurants, and Leisure
- Las Vegas Sands (LVS) Hotels, Restaurants, and Recreation
- Nike (NKE) – Apparel & Luxury Goods
- DR Horton Inc (DHI) – New Home Construction
- Wayfair – furniture and decoration
It should be noted that some of the companies listed above are less cyclical than others. For example, while Amazon is one of the world’s largest online sellers of non-essential goods, it now sells household items and, in most areas, even groceries. This growth in essential products will make Amazon less cyclical than, for example, an online furniture retailer like Wayfair.
How to invest in cyclical and cyclical consumer stocks
Do you expect the economy to enter or remain in a growth phase of the business cycle for the foreseeable future? If so, investing in cyclical stocks could provide an above-average return during expansion compared to consumer staples, which tend to grow more slowly and stably.
While you could go through the above list of cyclical stocks and examine each one individually to see which stock offers the best value, there is an easier way of getting exposure to cyclical and consumer cyclical stocks. That’s by investing an ETF that focuses on them.
The XLY (Consumer Discretionary Select Sector SPDR Fund), for example, is heavily weighted in cyclical consumer stocks (94.10%). Here are some more popular ETFs that invest in cyclical and cyclical consumer goods:
Remember that you pay a small fee to hold ETFs (called the fund’s expense ratio). If you already own some of the individual stocks in the ETF, purchasing fund shares will increase your exposure to that single name.
Most of the top stock brokers allow you to invest in any of the above ETFs without paying trading commissions. You can compare online stock brokers here >>
For those looking to keep their finger on the pulse of the economy, investing in cyclical and cyclical consumer goods can be a smart way to grow their portfolio in parallel with the wider economy. Remember that while these groups should do well during the expansion phase of an economic cycle, they should underperform during the contraction phase.