The price movements of cyclical stocks on the ASX tend to correlate closely with the performance of the broader economy. It seems cyclical shares perform well when the economy is booming, but their valuations can plummet during a downturn.
In this article, we look at what sort of shares are 'cyclical' and how you can use them in your portfolio.
What makes a share cyclical?
A cyclical share is a stock in a company whose performance is highly impacted by changes in the macroeconomic landscape.
Typically, the prices of cyclical shares will follow the broader economy as it cycles through regular periods of expansion and contraction. As the economy grows, cyclical shares tend to outperform other stocks — but when the economy is shrinking, they tend to underperform.
In contrast, defensive shares usually aren't as sensitive to changes in the overall state of the economy. Defensive shares are often described as 'recession-proof' and belong to companies that provide essential products and services, such as healthcare, critical infrastructure, and consumer staples.
Demand for these types of products and services remains relatively consistent regardless of how the broader economy is performing, which helps stabilise these companies' profits and share prices. And while defensive shares tend to preserve their value during a downturn, it also means they don't provide as much upside when the economy is booming.
Ups and downs
Cyclical shares, on the other hand, may lose a lot of their value during a recession — but they will often zoom higher as the economy expands. While defensive shares belong to companies that sell necessities, cyclical shares are more likely to sell discretionary items. These include luxury goods, electronics, or holidays.
Consumers will spend more on these items when household incomes are higher and the economy is expanding. But they are also likely to be the first things consumers cut back on when money is tight and the economy is in a downturn.
Examples of cyclical shares
Travel companies like Flight Centre Travel Group Ltd (ASX: FLT) and Qantas Airways Limited (ASX: QAN) are good examples of cyclical stocks. Holidays are probably one of the first things consumers will cut back on when financial times are tough.
And, despite pandemic-induced border restrictions easing, the share prices of these companies have remained stubbornly low due to high inflation and global recession fears.
Electronics retailers like JB Hi-Fi Limited (ASX: JBH) and Harvey Norman Holdings Limited (ASX: HVN) are also examples of cyclical shares. After severe price crashes at the onset of the pandemic in early 2020, both posted strong recoveries as the economic outlook improved over the remainder of 2020 and into 2021.
However, rising interest rates and the possibility of a near-term recession sparked renewed sell-offs in 2022.
How do you identify cyclical stocks?
As with defensive shares, cyclical shares are probably best understood by considering your household budget. Some things you spend money on will be essential — consumer staples like food, power, and perhaps even your internet connection.
However, there will be other things you spend your money on that you will be more willing to give up if you're strapped for cash — these might include designer clothes, meals out, home renovations, a new car, or holidays (as we touched on earlier).
We often refer to this second group of items as consumer discretionary because people are free to decide whether — and when — they buy them. Companies that sell these sorts of goods and services are typically cyclical.
When the economy is contracting — and aggregate household incomes are decreasing — companies that sell consumer discretionary products and services are likely to see their profits and share prices decline. When the economy is expanding, on the other hand, profits will increase, driving up their stock prices.
What are the stages in the economic cycle?
There are four stages in the economic cycle.
- Expansion: This is a period of relatively rapid economic growth. During this phase of the economic cycle, interest rates typically tend to be low, gross domestic product (GDP) is increasing, and inflationary pressures may start to build.
- Peak: Economic growth rates hit their maximum during the peak phase of the cycle. This is often accompanied by high inflation rates, which may require central banks to intervene in the economy to tamp down growth by hiking interest rates.
- Contraction: As interest rates rise, the economy will start to cool off. In this cycle period, growth rates will slow and unemployment increases as consumers and businesses cut back on discretionary spending.
- Trough/recovery: The opposite of a peak, this is when the economy hits its low point and begins to recover. From here, the economy will roll back around to its expansionary phase, and the cycle will repeat itself.
Why invest in ASX cyclical shares?
Because cyclical shares tend to outperform the rest of the market when the economy is expanding, investing in them can help magnify your portfolio's returns in boom times. This leads many investors to try and 'time the market' by buying cyclical shares when the economy is bottoming out and then selling them at their peak.
However, timing the market can be challenging — and risky — in practice. None of us can predict precisely when the economy will transition through the stages in its cycle or how long each phase might last.
And there are also likely to be many other risk factors and economic events which can cause volatility in certain industry sectors or in particular shares. For these reasons, generating consistent, long-term profits by attempting to time the market is tough.
This doesn't mean you should avoid cyclical shares entirely — they can be a great way to generate additional upside in a thriving economy. Just remember to combine them with other, less volatile shares — like stocks in defensive companies — in a well-balanced, diversified portfolio. This will help you generate sustainable, long-term returns with fewer bumps along the way.
How do they fare in a volatile market?
Market volatility occurs when investors are uncertain about the future state of the economy. When the economy is healthy and the future seems more predictable, it is much easier for market participants to come to a consensus about how shares should be priced. This creates market stability because investors have more confidence that they are paying a fair price for a share.
When there is a lot of uncertainty, it is harder for the market to agree on how shares should be priced. High inflation, unpredictable interest rate rises, and volatility in commodity prices can create uncertainty in share markets because they can potentially pressure companies' profit margins.
As you might expect, cyclical shares tend to be particularly volatile in an uncertain market. Because their fortunes are so closely tied to the future health of the economy, the prices of cyclical shares can fluctuate wildly with changing economic expectations. This means that if you had a portfolio comprised solely of cyclical shares, it would likely exhibit more volatility than the overall market.
Is investing in cyclical stocks right for you?
Investing in cyclical shares can be a great way to magnify your portfolio's returns when the economy is expanding.
However, it is essential to remember that cyclical stocks will also most likely increase your losses during an economic downturn or recession.
Therefore, consider your risk appetite, investment objectives and time horizon before investing in ASX cyclical shares.
