by Catriona on June 3, 2014

All of the investment manuals talk about economic cycles and how different asset classes are affected depending on where in the cycle we are.

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 the UK boom banks and house builders were clear winners as we all flocked to get mortgages to buy houses.  Car manufacturers did well too.  These can be considered as luxury items or non-essentials and share prices of these companies will 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 round 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 We Invest in Non-Cyclical 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.

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