01 Jan Economic Correlation: Cyclical and Non-Cyclical Stocks
A rising tide might lift all boats, but the same cannot be said for the economy.
When the U.S. experiences robust economic growth, certain sectors of the stock market tend to rise while others hold steady or even decline by comparison. The stocks of companies that experience higher revenues are typically categorized as cyclical. In other words, their good fortune rests mainly on consumers being gainfully employed and having ample discretionary income with which to buy more goods and services.
Take, for example, auto manufacturers. Sales typically increase when more people can afford to buy a new car. But that’s not all the time, because the economy is cyclical – it ebbs and flows over time. Therefore, companies that produce non-essential products – sometimes referred to as consumer discretionary goods and services – tend to flourish during economic cycles of strength and rising GDP. That is why they are called cyclical stocks.
But when the economic future is in decline or at least uncertain, people tend to delay buying non-essential items like a new car. When the economy really takes a nosedive, more consumers are affected, they buy less stuff, manufacturing takes a hit and companies start laying off their workforce.
Despite these unfortunate circumstances, people still have to eat. They buy essential items, such as food and toothpaste and toilet paper. These are considered consumer staples, and the stocks of companies that produce these types of goods are defined as non-cyclical stocks. That’s because those companies are expected to continue earning revenues regardless of economic cycles. Non-cyclical industries include food and beverage, tobacco, household and personal products.
Another non-cyclical sector is utilities. Utilities are a little bit different because people tend to purchase relatively the same amount of utility service – with exceptions for extreme weather or making slight thermostat adjustments to save money – whether the economy is robust or in a downward spiral. Because of this, utility companies are considered a very stable business model.
For investors, that means they are well-established, long-term performers and usually pay out high dividends. Not only are utility stocks a good option for retirees seeking income to supplement their Social Security benefits, but they offer a safe haven for investors to relocate assets during periods of economic decline.
In light of recent cautions by economists predicting a recession in 2020, this could be a good time to review your portfolio from the perspective of cyclical versus non-cyclical holdings. It doesn’t mean you need to sell completely out of your stock allocation; perhaps just temper your holdings to equities that tend to perform reliably regardless of the economy. In addition to consumer staples and utilities, consider companies that specialize in national defense, waste management, data processing and payments.
Also be aware that the past three decades have boasted several of the longest running economic expansions in U.S. history (1991 to 2001; 2001 to early 2007; 2009 through 2019). What this tells us is that U.S. economic growth cycles appear to be lengthening while declines are relatively shorter and followed up with impressive recovery periods.
So, take heart. If you decide to transfer some of your assets to less flashy, non-cyclical securities, you might not have to leave them there for long. However, it’s always a good idea to maintain a diversified portfolio so you don’t have to make adjustments based on economic cycles. And as always, consult an investment professional to help you make these important decisions.