What are cyclical industries and sectors?
Cyclical industries are those that are economically sensitive. This means they follow the ups and downs of the economy as a whole – becoming profitable during periods of prosperity and inactive during downturns.
This cycle is largely down to consumer spending. If a good or service is seen as a discretionary expense – an optional cost – then the companies involved would usually only see profitability if consumers have sufficient incomes.
Common examples of cyclical industries include automobile manufacturers, luxury goods producers, airlines, hotels and restaurants. When consumers have excess capital, they are more likely to make extravagant purchases or go on holidays, but during times of economic hardship consumers tend to stop spending and start saving.
What are cyclical stocks?
Cyclical stocks are units of ownership in these companies whose profits depend on the business cycle. The price of cyclical stocks usually rise in periods of economic boom – and can even outperform the wider market. But their value usually falls during downturns, in line with sales and profits.
To illustrate the ups and downs of cyclical stocks, we’ve plotted the share price of luxury goods producer Burberry (BRBY) against the FTSE 100 – a common benchmark for the health of the UK economy – from May 2018 to May 2020.
Cyclical vs non-cyclical stocks
Non-cyclical stocks – also known as defensive stocks – are the shares of companies that tend to be profitable regardless of the state of the economy. Unlike cyclical stocks, they produce the goods and services that society can’t do without, such as utilities or food companies.
This means that the price of defensive stocks will likely remain stable, or even rise, during periods of increased volatility. As a result, investors and traders often use defensive stocks as safe havens or to hedge against falling markets.
What you need to know before trading cyclical stocks
Cyclical stocks are volatile
Cyclical stocks are often far more volatile than non-cyclical stocks because they see significant growth during periods of economic health, and rapid declines during downturns.
Their volatility makes them particularly interesting for shorter-term trades to capitalise on intraday falls or to hedge against losses to your existing shareholdings. Using derivatives, such as CFDs and spread bets, would enable you to trade both rising and falling markets.
For longer-term trades or investments, you might need to consider ways to diversify your portfolio as cyclical stock volatility does create risk.