How to Differentiate Between Cyclical and Non-Cyclical Stocks

All the investment manuals talk about economic cycles and how different asset classes are affected depending on where in the cycle we are. This article explains the difference between cyclical and non-cyclical stocks and also advises the appropriate investment ratio to use as you prepare for your CII AF4, J10, J12 or R02 exam.

Cyclical stocks are affected by the Economic Cycle

The performance of a cyclical stock is dependent on where we are in the economic cycle too; in other words, they are highly correlated to economic activity.  They do well when the economy is at the boom stage – they will enjoy growth in profits as sales go up.  They will do badly when the economy goes into recession.

During a boom, banks and housebuilders do well as we all flock to get mortgages to buy houses.  Car manufacturers tend to do well too; these are considered as luxury items or non-essentials and share prices of these companies go down in a recession as unemployment rises along with interest rates and we put off buying such luxuries as new cars.

Economic activity has little impact on non-cyclical stocks

A non-cyclical share is one which has very little correlation to economic activity; whether we are in a boom or in a recession the earnings of these companies remain pretty much the same.  Examples are utilities, household and personal care items and tobacco – we all need gas and electricity and we still keep buying soap and shampoo regardless of how tight money is!  These shares are also known as defensive stocks and we can think of them as the essentials that we always need.

Anyone trying to create a balanced portfolio should incorporate both cyclical and non-cyclical shares – that might sound easy enough, but identifying those companies and when to invest is complex.

When should we invest in cyclical stocks?

In theory, we should be investing in cyclical stocks just after coming out of a recession, when people are more optimistic and decide to buy that car they’ve been putting off during the tough times.

Which investment ratio should be used to assess cyclical stocks?

If investment ratios are used to help with investment decisions, then the cyclically-adjusted price earnings ratio should be used.  The PE ratio is a widely used method of valuing a company, but cyclical companies, as we’ve seen, have profits closely related to the economy and so their PE ratio (share price divided by current earnings) can be misleading.  To get around this, profits are averaged over 7 to 10 years to take account of the business cycle.  This then gives a cyclically-adjusted price/earnings ratio, which gives a more accurate picture of whether the share is a good buy or not.

When should you buy defensive stocks?

As for defensive stocks, it should always be the right time to buy them, but the best time would be at the start of a downturn when they can provide a safety net when economic conditions become unstable.

Grab the resources you need!

If you’re studying for your CII R02 exam, and you’re wanting extra confidence on exam day, grab our free taster to try out one of Brand Financial Training’s resources for yourself.  Click the link to download the R02 calculation workbook taster now!

Alternatively, you can download taster resources for AF4, J10 or J12 if you’re revising for one of those exams.