Companies whose stocks are cyclical need economic growth to produce returns for investors. These are the companies that make the products and services that many everyday consumers can do without during lean times. Consumer spending levels and unemployment rates are two major influences on cyclical stocks, which generally only produce strong returns when the economy’s gross domestic product is growing.
Cyclical and Defensive Stocks
Cyclical stocks are affected by the economy and generally only perform well during periods of overall economic growth. Automobiles and jewelry, especially luxury items, are common cyclical stocks. Other cyclical industries include aerospace, telecommunications, retail, travel, financial services and technology. These essential items, including automobiles or smartphones, will suffer lost sales during these cyclical periods, as consumers go one or two more years before upgrading. Cyclical stocks are the opposite of defensive stocks, which are companies that maintain strong performance during weak economies. Companies that provide health care, food and beverages, utilities and other essential products or services are classified as defensive stocks.
Gross Domestic Product
Cyclical stocks are affected by the economy’s overall performance, which is measured by the gross domestic product, a measurement of economic output. A growing economy needs increases in either product supply or consumer demand. Lower unemployment levels and higher consumer spending are crucial for growth in many cyclical stocks. Government spending, levels of investment, taxes, consumer spending levels, imports and exports, interest rates and a slew of other factors can affect the economy, and each can have different levels of impact. But there are several indicators that investors can follow to help understand economic conditions.
Indicators and Indexes
Cyclical stocks can produce strong returns during solid economies, especially if investors buy them early in a market rebound. By following relevant indexes and financial indicators, investors can stay ahead of the economic conditions and anticipate growth in GDP. The Dow Jones industrial average is one of the most followed indexes for gauging overall economic strength, but other indexes can help pinpoint certain industries or markets. For example, the Russell 2000 index tracks small-cap stocks while the S&P 500 gives a broader read on the economy, since it tracks the largest 500 stocks, as opposed to just 30 for the Dow.
Rises in stock prices don’t necessarily equate to stronger consumer purchasing power. This is better followed through the Consumer Confidence Index or similar indicators designed to track how much people are saving vs. how much they are spending. According to MarketWatch, cyclical stocks have a history of overperforming when unemployment rates drop. Interest rates, housing values and energy prices are other factors that can impact GDP growth, and thus, returns on cyclical stocks.
Investor sentiment can also influence the performance of cyclical stocks, which financial analysts will sometimes measure against defensive stocks. Analysts use the price earnings ratio to compare the value of stocks with different prices, calculated as a ratio between the stock’s earnings-per-share and its share price. Some financial analysts look for buying opportunities when cyclical stocks have lower P/E ratios and are considered undervalued against defensive stocks. In these cases, investors may be slow to adapt to a growing economy and may remain unnecessarily pessimistic about higher market indexes or other signs of growth, reports the Motley Fool website.
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