Cyclical stocks can experience drastic swings—so pick them wisely
Cyclical stocks regularly rise and fall in price, with those movements usually tied to business or economic cycles.
All in all, though, when times are good, investors in cyclical stocks sometimes ignore investment drawbacks and pitfalls. When times are bad, many investors pay too much attention to risk.
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Cyclical sectors, like resource and energy stocks, are subject to wide and unpredictable swings. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up.
Stock market cycles occur repeatedly—and there are any number of theories as to which sectors will outperform at any given short term stage of the cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. That’s because to succeed, you need to guess right twice. You have to pick the top sectors, and then pick the stocks to rise within those sectors. Consistently succeeding at both is extremely difficult.
Defensive stocks (unlike cyclical stocks) can protect your portfolio against economic or stock market downturns
The most defensive stocks are in the Consumer sector. They benefit from continuous, habitual use and have a steady core of sales, regardless of the economy and business cycles.
Defensive stocks in the Consumer sector can provide protection against economic downturns. That’s a key difference between Consumer stocks and companies in the Manufacturing & Industry or Resource sectors, which are far more sensitive to the ups and downs of the economic cycle.
At the same time, as a general rule, resource stocks provide the most effective hedge against inflation because they directly gain from rising prices of the commodities they produce. Utility stocks used to provide a hedge of sorts against recessions, due to their steady, regulated earnings and dividends—but many now have a big part of their operations in unregulated businesses.
However, although it pays to be aware of these general tendencies, you should resist the temptation to fine-tune your portfolio according to theories or predictions about inflation and economic downturns. No one has ever consistently predicted either one, either in timing or degree, so most investors will want to include stocks from most if not all of the five economic sectors in a well-balanced portfolio.
When to buy cyclical stocks
It’s best to buy cyclical stocks when their P/Es are in the middle of the historical range—neither too high nor too low. The main exception is when their earnings have collapsed and driven their p/e’s sky-high. This is often a good time to buy cyclicals, since it coincides with a low in their earnings.
P/E (price to earnings) ratios—the ratio of a stock’s price to its per-share earnings—are published regularly in newspapers and on the Internet. These financial ratios are widely followed, and are an important part of many investors’ decision making.
By themselves, P/E’s can steer you wrong on individual stocks, and on the market in general. There are lots of stocks out there that are cheap on a P/E basis. But many will remain cheap—their share prices won’t be rising any time soon.
You need to ask yourself if a P/E is telling you something by being unusually high or low. In the worst cases, buying stocks with low P/Es, and thinking that alone means you’re buying value, is often like boarding a train before it derails.
Using the P/E ratio is a good starting point for researching a stock you’re considering buying (or selling). But relying too heavily on them can expose you to serious risk.
Because they receive so much attention in brokerage and media reports, price/earnings ratios may seem like the key to whether a stock is undervalued or overvalued. But like any other single factor, an attractive P/E should encourage you to look more closely, to see if it gives you an accurate or misleading indication of the stock’s value.
Strong potential for long-term gains
You will improve your chances of making money over long periods, no matter what happens in the market, if you diversify your holdings across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities.
For example, Manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.
If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the attractiveness of your Utilities stocks.
Are you currently holding any cyclical stocks in your portfolio? How have they performed for you? Share your story with us in the comments.
This post was originally published in 2009 and is regularly updated.
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