Cyclical and Defensive Stocks

Economies move in cycles. They expand, to a point where they overheat and inflation may get out of control, and then they cool down, most commonly to standstill or contraction. Growth and recession seems to be part of the modern world, and is most commonly measured by reference to the Gross Domestic Product (GDP) of a nation.

The GDP is the value of all goods and services within an economy, and can be measured in a simple form by adding up everyone’s income or spending (logically these two should be equal, but spending on credit distorts these numbers). GDP is usually measured on an annual basis, and then announced in terms of percentage change from the previous quarter and the previous year.

At the top of the economic cycle, most money is being spent. But spending habits change through an economic cycle. When times are good, consumers will buy more of what they want, and when times are bad this spending becomes restricted to necessary items. In other words, discretionary spending increases as the economy improves and peaks at the top of the cycle whilst necessary spending is likely to remain fairly constant throughout.

It is the economic cycle and our habits as consumers that define the difference between cyclical and defensive stocks.

Cyclical stocks are likely to outperform defensive stocks as the economy is improving and while it is operating at peak, while defensive stocks are likely to outperform cyclical stocks when the top of the economic cycle has passed and through the recessionary phase.

Cyclical Stock Sectors

When identifying cyclical stocks and sectors, it is perhaps easiest to think about the types of goods and services that we will be more likely to use when we have excess cash in our pockets. Our spending habits change, and we begin to buy the items that we would like to own rather than (or as well as) the items we need.

When times are a little harder, our spending is dictated at least as much by affordability as by desire. When work is plentiful, wages rising, job offers ten-a-penny, we are more likely to visit a car showroom and buy the cabriolet we always wanted, but when we are living in fear of losing our jobs, then perhaps taking our current model to the service station is more appropriate. Car manufacturers and dealers are most definitely on the list of cyclical stocks.

We all need to eat, of course, but when we have cash in our pocket we are more likely to take the family to a restaurant, maybe even high end, rather than  face the drudgery of the washing up after a meal. Restaurant chains are also on the list of cyclical stocks.

Other sectors that prosper most through the good times include house builders, hotels, airlines, and travel companies. Any company that manufactures or sells luxury goods and services also belong on the list of cyclical stocks.

Defensive Stock Sectors

On the other hand, when times are tough, and we are living in fear of losing our jobs, then our spending contracts. We tend to see the future with pessimism and spend accordingly.

That car that would be bought in the good times can wait a year or two. But there are essentials that we all require to live, and live in comfort.

For example, we all need to eat. But it’s cheaper to eat at home rather than eat out. As a treat we might take the children to MacDonald’s, or visit a ‘proper’ restaurant once a fortnight. Other than this, we’ll buy more at the supermarket and eat in. Food retailers, particularly no frills chains, and fast food restaurants are defensive stocks.

We need heat and lighting, too. And water, to drink, cook with, and bath in. Utility companies are top of the list of defensive stocks, and often have a captive audience as their customer base.

The same with healthcare companies: health is important to most people, and governments tend to spend more on healthcare when times are tough. Pharmaceutical companies, drugs manufacturers, and medical insurance companies weather an economic downturn well.

Companies that produce non-durable goods, such as household supplies, soaps, detergents, and toothpastes hold sales steady throughout an economic cycle.

Price performance of cyclical and defensive stocks

When the economy is roaring, and we are doing well and spending more, companies that produce goods or services that pander to our desires rather than our needs sell more. Revenues increase, companies can raise prices more easily and margins grow. When the economy falters, so too does our spending. Cyclical companies have to respond to falling demand by cutting prices, and margins retreat. Cyclical stocks tend to rise and fall with the economic cycle.

Dividends, too, paid by cyclical companies will be better when the economy is expanding, and worsen when the economy comes back.

Defensive stocks tend to see sales remain relatively stable throughout a cycle (though some discount manufacturers benefit more due to pricing policy). Revenues, earnings and dividends tend to stay ion an even keel, as do dividends.

Theoretically at least, an investor should buy a cyclical stock as the economy is recovering and prepare for the share price rises to come. As the economy hits its peak, and GDP growth starts to ease back and turn neutral or negative, then defensive stocks will outperform cyclical stocks.

In conclusion

Understanding how cyclical and defensive stocks behave through an economic cycle will help you to make better investment decisions and time fund switches with better accuracy for long term portfolio health. Of course, defensive stock prices may also fall during a large scale recession, but they are likely to hold better than cyclical stocks, and also more likely to continue to pay dividends.