Cyclical stocks rise and fall with the economy, and are associated with industries where demand shifts based on economic conditions. Investors cannot control their movement, but can structure trading strategies to increase potential earnings.
Cyclical stocks are stocks that tend to move with the current economic trend. When the economy is growing, the stock value of a cyclical stock will rise. During times when the economy is experiencing some type of recession, the stock will decline. Typically, cyclical stocks are associated with industries where demand shifts based on what’s happening in the economy, not industries where demand tends to stay constant.
An example of a sector where cyclical stocks are found is the automotive industry. When the overall economy is growing, consumers have more disposable income and are more likely to buy new cars. This recovery in consumer demand continues as long as economic growth is underway. If the economy starts to stall and households no longer have the disposable income they used to, the end result is that demand for new vehicles decreases, which in turn drives down the value of shares issued by automakers.
Cyclical stocks can also exist in specific sectors of various markets. During an economic downturn, consumers may buy less of a particular type of good by increasing their demand for other goods. This is true when it comes to food. When disposable income is lower, a household can buy less meat each week and use a portion of those savings to purchase various types of beans as a substitute for meat. In this scenario, the bonds issued by companies that produce meat as their staple supply will decrease slightly, due to the change in demand. Demand for beans as a substitute for meat can create what is sometimes called a countercyclical inventory build-up, as such an increase can be directly linked to the economic downturn and the resulting change in consumer buying habits.
It is important to note that investors have no control over the movement of cyclical stocks. This makes it all the more important to accurately project the direction the economy will move in both the short and long term. In this way it is possible to structure trading strategies that allow the investor to buy shares of stocks that could thrive in the coming months and years, while selling shares that could fall in value during the same period. Creating the right combination of buying and selling leads to taking the economic trend to its obvious conclusion and increasing the potential for consistent earnings.
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