You often hear about cyclical and non-cyclical stocks. Let’s understand what that means.
Cyclicality tells us that a company’s performance is tied to the stages of a business cycle-usually 10 years. Cyclical companies follow the trend in the economy, all the ebbs and flows – accordingly, these stocks are more volatile: they price aggressively during an expanding economy and then fall during a cooling economy.
Cyclical goods and services include second necessities and many durable goods: cars, furniture, luxury goods, branded clothing, restaurants, hotels, and airline tickets. Consumers actively use them when the economy is booming, but if purchasing power falls, they are discarded first. Consequently, cyclical revenues decline during this time. If the downturn is prolonged and the company’s fundamentals are weak, bankruptcy becomes likely.
Non-cyclical companies, on the other hand, show stable revenues regardless of the economic situation, because they provide essential goods and services. Even in the hardest of times, people continue to use food, medicine, tobacco, alcohol, electricity, water and gas.
Therefore, the consumer staples, electricity, and healthcare sectors can be classified as protective: they are more conservative and do not experience dramatic fluctuations.
The Four Stages of the Business Cycle
My portfolio consists of three parts: investment, speculative and hedging. The proportions of these parts change depending on strategy and the current phase of the economic cycle.
For example, before a recession, investors increase the hedging part, i.e. they bet on protective assets: gold, currencies, short bonds. And at the beginning of the business cycle, they aggressively enter growing assets, increasing the investment and speculative parts.
Understanding which stage of the business cycle we are in helps prepare your portfolio for the next economic phase: before a recession, reduce the shares of cyclical sectors and shift capital to hedging assets, and after a strong market crash, on the contrary, load the investment side – invest in those sectors and industries where explosive growth is expected at the beginning of the next business cycle.
Every business cycle is unique, but there are patterns. An analysis of key macroeconomic indicators helps us recognize which economic phase we are in and anticipate future changes. Although unforeseen global events and shock scenarios are possible, it generally provides a benchmark for organizing a portfolio.
There are four phases within the business cycle: early, middle, sunset and recession. We are now entering the last phase.
The early phase is characterized by a sharp recovery from the recession. There is an increase in economic activity, an increase in production capacity, and an acceleration of GDP growth. Monetary policy is easing, favorable credit conditions are being created, investment and employment are growing, and sales are increasing.
Fidelity’s study analyzed market behavior since 1962. According to the study, the early phase lasts, on average, about a year and is accompanied by a maximum market growth of about 20%. This phase signifies economic recovery and is characterized by low rates and a surge in lending, which benefits financial institutions. Production and sales of second necessity products and durable goods are actively growing. As a result, the following three sectors are showing good growth:
In addition, these sectors are positive in the early phase in anticipation of an economic recovery:
IT, Information Technology.
Industrials, the industrial sector, especially capital goods and carriers.
Materials, the commodities sector.
As the economy emerges from its early phase and gains strength, interest-rate-sensitive sectors are gradually losing their lead. The growth rate of the entire market is still high, up to 15% per year.
Below in the screenshots are the sector indicators relative to the market. Let me analyze the figures and explain what they mean.
Geometric average – the geometric average of the sector growth for the whole phase of the business cycle relative to the total market.
Median Monthly Difference – the median monthly difference, that is, the average monthly difference between the growth of the sector and the growth of the whole market.
Hit rate – the frequency of hits, i.e. cases when the sector outperformed the market, if we take all seven business cycles since 1962.
Judging by the early phase chart, the Real Estate, Financials and Consumer Discretionary sectors show the largest positive median difference with the overall market, while Energy and Utilities are negative – that is, lagging far behind the market.
The consistency of sector behavior can be seen on the scale to the right: Consumer Discretionary has become the most predictable, outperforming the overall market early on in all of the business cycles examined. Industrials also shows a high degree of consistency. But Energy, Utilities, and Communication Services have never been able to outperform the market early on. As for the Communication Services sector, which has been reshaped and augmented by the media industry in 2018 – Fidelity analysts no longer have confidence that the identified trend will continue. In the next business cycle, this sector is likely to behave differently.
The middle phase is usually the longest phase of the cycle, in which economic growth peaks. The market is saturated, and competition is gradually increasing. All production and labor capacities are utilized. Inflation is often on the rise.
The IT sector performs best in this phase – largely due to the semiconductor and hardware industries: they tend to gain more momentum as soon as the economy reaches stability and business capital spending increases. Communication Services can compete with it, thanks to the media, entertainment and interactive services industries.
How much will you earn if you buy shares of the show’s creators instead of watching them?
The middle phase of the business cycle is the longest: about 3.5 years. It accounts for the greatest number of stock market corrections. For this reason, the leadership of the sectors changes frequently, and the difference between their performance is minimal.
Sunset. Growth slows down. There is overproduction of goods and services, stocks in warehouses are growing and sales are falling. Monetary policy tightens; central banks can resort to artificial stimulus. Companies buy back their own stocks because they see no further avenues for expansion.
The sunset phase lasts on average 1.5 years, and during this period, the market is up about 6% annually. The oil and gas sector comes out on top because it depends on oil prices – and they tend to rise because of the inflationary pressure that is forming by this time.
Meanwhile, noticing the economic slowdown, investors are beginning to shift their capital into protective, non-cyclical sectors such as utilities, healthcare, and consumer staples.
Recession. It is a natural process when the economy cools after years of growth. Corporate profits decline, industrial production slows. Inventories in warehouses and sales fall. Unemployment rises. Central banks move to tight stimulus. A recession is fixed when there are two consecutive quarters of zero growth or decline in gross national product.
The recession phase is historically the shortest, averaging just under a year. The market shows an average 15% annual decline. The defensive sectors perform better than the rest of the market, as non-cyclical companies continue to generate more or less steady revenue. Quotes are also helped by the high dividend yields provided, for example, by utility and telecom companies.
The crisis is the acute phase of the recession. A reset occurs: inefficient companies die off, while strong companies take over their market and enter a new round of growth.