Glossary
Cyclical Stock
A stock whose earnings rise and fall strongly with the business cycle, such as automakers, airlines and industrial firms.
A cyclical stock belongs to a company whose sales and profits swing with the economy. When growth is strong and people feel flush, they buy cars, book flights, renovate homes and build factories, and these companies' earnings can jump. When a Recession arrives, those purchases are the first to be postponed, and profits can collapse just as fast.
Typical cyclical industries
- Autos and auto parts
- Airlines, hotels and cruise lines
- Homebuilders and building materials
- Industrial machinery, chemicals and steel
- Semiconductors and many consumer-discretionary retailers
- Banks, whose lending and loan losses track the credit cycle
The opposite group is defensive stocks, such as utilities and consumer staples, whose demand holds up in downturns.
Why earnings swing so much
Many cyclical businesses have high fixed costs: plants, fleets and payrolls that cost roughly the same whether they run full or half empty. That operating leverage magnifies changes in sales.
Valuation trap
The Price-to-earnings ratio (P/E) behaves oddly for cyclicals. At the top of the cycle, peak earnings make the stock look cheap on a low P/E just before profits fall. Near the bottom, depressed earnings make the P/E look very high just as recovery begins. Analysts therefore often value cyclicals on normalized, mid-cycle earnings or on book value instead.
Investors who follow Sector rotation tend to favor cyclicals when they expect the economy to accelerate, but timing the Business cycle is hard and the stocks often move months before the data do.