Cyclical stocks refer to those which are readily affected by business cycle fluctuations. Companies issuing such stocks enjoy high demand for their products during the boom period of an economy, which increases their share prices. In times of downturn of the business cycle, residents significantly reduce their demand for such items, consequently decreasing the share prices as a result of lower profits released.
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Interdependence of Cyclical Stocks and the Business Cycle
A thorough understanding of the business cycle is required to predict the stock price movements of cyclical shares. During times of economic boom, an optimistic spending and investment pattern is observed among individuals residing in a country. With relatively higher per capital incomes, residents often tend to spend more on comfort and luxury items, thereby increasing the profitability of companies manufacturing such items.
Mostly, consumer utility items such as television, refrigerator, air conditioning units, cars, etc. fall under this category. During times of economic expansion, organisations manufacturing the aforementioned items experience highest growth levels in terms of profitability, due to increased market demand of the same.
Also, higher spending capacity of individuals often increases their speculative demand limits, as they are willing to procure a higher number of shares to substantiate overall stock market returns.
Higher profitability of such companies coupled with increasing demand for corresponding shares increases the average share prices in the market, which, in turn, increase their revenue-generating capacity even further, due to increased cash flow.
However, in times of economic downturn, cyclical stock companies are hit the hardest. Recession is characterised by an economic slowdown, affecting the production and employment levels. As the unemployment level rises, the demand for consumer utility goods falls first, leading to a drastic fall in total revenue generation and corresponding profit level. The share prices of most cyclical stocks plummet in such an economic scenario, due to lower production levels of such companies as well as lower demand for stocks in the trading market.
Thus, business cycle fluctuations and cyclical stock performance are directly related, as an upward movement in the economic performance increases the profitability of issuing companies manifold, while a downtrend of the business cycle causes a steep fall in gains realised by such businesses.
The benefits of investing in best cyclical stocks can be stated as follows –
- High returns
As explained above, the systematic fluctuations of the stock market heavily influence the performance of the best cyclical stocks. Thus, during expansion and peak phases of the business cycle, underlying companies are reported to generate substantial returns on investment. Individuals can expect extensive wealth generation by investing in such companies, as the stock prices appreciate manifold during optimistic economic conditions.
- Easy identification of stocks
Cyclical stock companies can be easily spotted in the stock market as they primarily produce goods and services categorised as comfort and luxury goods. While it is not necessary for survival, people having higher disposable income often opt to purchase such goods to increase their standard of living.
Individuals can easily isolate such companies in the market, and procure stocks of the same to realise gains from business cycle fluctuations respectively.
- Simple stock market predictability
Business cycle fluctuations fall under systematic risk and can be easily spotted by keeping track of the GDP growth rate of a country. Individuals not fully adept with the workings of the stock market can still predict such fluctuations beforehand and realise substantial gains by purchasing corresponding shares as per the corresponding stage of the business cycle.
Limitations of Cyclical Securities
While investing in the best cyclical stocks can lead to extensive profit realisation, certain restrictions of such shares should be kept in mind to ensure maximum profitability from such investment –
- High Risk
The price of a cyclical equity share is associated with severe fluctuations, corresponding to business cycle changes. In the event of the downturn of the production cycle, the share prices of such companies fall drastically, implying severe losses for individuals deciding to sell their stocks during such times.
- Uncertain profits
Consumer utility goods are heavily dependent on the tastes and preferences of citizens. With evolving technology leading to the launch of new gadgets every day, companies engaged in the production of such items often lose their competitive edge if they fail to keep up with the latest trends and customer preferences. This might lead to significant losses even during times of economic boom owing to reduced demand for outdated products supplied, leading to reduced prices of cyclical shares.
Cyclical Vs. Non-Cyclical Stocks
|S. No.||Point of difference||Cyclical Stock||Non-Cyclical Stock|
|1.||Risk||High risk||Low risk|
|2.||Returns||High returns during uptrend of the business cycle||Stable performance|
|3.||Sectors||Companies producing consumer utility items||Defence sectors, pharmaceutical companies, etc.|
Individuals investing in cyclical shares can incur profits in two ways – dividend pay-outs or capital gains. Dividend pay-outs do not require tax payments by investors directly, as issuing companies are required to pay the same before distribution of yields. Nonetheless, the Union Budget of 2016 announced a 10% dividend tax on total dividend income higher than Rs. 10 lakh annually.
Capital gains, on the other hand, can be taxed depending on the holding period of cyclical stocks by investors. Resale of share prior to completion of one year attracts short term capital gains tax at 15% of total profits. Subsequently, if the holding period exceeds one year, tax is deducted at 10% of the total profits under long term capital gains tax if such capital gain exceeds Rs 1 Lakh.
Individuals well versed with stock market fluctuations and having extended investment tenure can opt for cyclical shares for wealth accumulation. Also, investors should be prepared to assume extensive risks, as business cycle upturn and downturn generate an effect in tandem on cyclical stocks.
Hence, risk-prone individuals who have a thorough understanding of the fluctuating patterns of the business cycle and can predict economic trends accurately should include such cyclical securities in their investment portfolio to increase the expected return rate.
As the performance and rate of return on investment in cyclical stocks are heavily dependent on business cycle fluctuations, the pattern in nature of variations has to be recorded to ensure investment is made at the right time.
Investing in cyclical stocks during a recessionary phase in the economy often leads to extensive capital gains during a revival of such an economy, as demand slowly picks up, having a positive impact on the stock prices. Individuals having an investment goal of capital gains should look out for adverse business cycle fluctuations for this purpose.
On the other hand, investors looking for periodic dividend pay-out benefits should purchase cyclical stocks during the recovery phase of a business cycle, demonstrating gradual improvement in the stock prices. As the sales level increases manifold during such time, the net profits realised rise as a result as well, allowing cyclical stock companies to announce dividend pay-outs frequently.
Thus, individuals choosing to invest in companies issuing cyclical stocks should analyse the current business cycle trends, and expected rate of return on investment to maximise the gains realised. Consequently, the risk factor should also be taken into account to ensure no financial strain is imposed on individuals due to stock market fluctuations. After taking into account all these parameters, investment is likely to yield extensive returns if the total portfolio is kept locked in for an extended period.