Investing in cyclical stocks feels like riding a roller coaster. I’ve seen people make fortunes during boom times, especially in sectors like automotive, consumer discretionary, and industrials. Yet, the very nature of these stocks means they can swing wildly depending on the economic cycle. For example, during a recession, these sectors can see their revenues drop by as much as 50% or more. A prime example is the automotive industry, which saw unit sales drop from around 17.5 million vehicles annually in the U.S. in 2017 to about 10.4 million in 2008 during the financial crisis.
The price volatility of cyclical stocks often scares away conservative investors. Imagine owning a stock that can swing from a peak of $100 to a trough of $30 within a year. At the height of the dot-com bubble in the late 1990s, many tech companies saw their stock prices soar, only to come crashing down by as much as 75% when the bubble burst in 2000. This volatility means you need to have a high risk tolerance and be prepared for significant price swings.
Timing the market accurately is another daunting aspect. Should you buy at the start of an upturn or sell before a downturn? History suggests that catching these inflection points accurately is extremely challenging. According to a study by DALBAR, the average investor underperformed the S&P 500 by about 4.23% from 2009 to 2019, largely due to poor market timing. In other words, trying to time the market usually results in lower returns, especially with cyclical stocks.
Another risk that often gets overlooked is the impact of high leverage. Many companies in cyclical industries tend to take on significant debt to finance growth during boom periods. When the economy slows down, these debts can become a heavy burden. For instance, during the 2008 financial crisis, General Motors had nearly $30 billion in debt, which eventually led them to file for bankruptcy protection. If you’re not wary of the balance sheet, you might find your investment declining rapidly in value.
Also, consider the concept of earnings volatility. During good times, earnings can grow exponentially, sometimes showing year-over-year growth rates of 30% or even more. Oil companies, for example, saw triple-digit profit increases during the oil boom in the mid-2000s. However, this also means that during downturns, these companies can see their earnings decline just as dramatically. This earnings variability can make it hard to gauge a fair valuation for the stock.
Liquidity risks are another factor. During downturns, the market for cyclical stocks can dry up quickly, leading to wider bid-ask spreads and increased difficulty in finding buyers. An example would be small-cap industrial stocks, which can sometimes see their average trading volume drop by 40% or more during recessions. If you need to sell your shares during such times, you might have to accept a lower price than you’d hoped for.
If you’re looking at dividends, cyclicals can be a mixed bag. Some companies might offer high yields during good times but slash or suspend dividends when the economy turns south. Royal Dutch Shell, for instance, had to cut its dividend for the first time since World War II in 2020 due to plummeting oil prices caused by the COVID-19 pandemic. If you’re depending on these dividends for income, such cuts can be a financial shock.
Cyclical stocks also face sector-specific risks. For instance, the steel industry heavily depends on construction and automotive sectors. A downturn in these industries can lead to excess inventory and significant revenue declines for steel companies. During the early 2000s, U.S. steel companies faced enormous challenges as both automotive and construction sectors slumped, leading to layoffs and factory closures.
Furthermore, technological advancements or changes in consumer preferences can render a once-thriving cyclical industry obsolete. Think of how the rise of digital media has impacted print newspapers. Companies that fail to adapt may see their stock prices fall irreparably. In the early 2000s, the newspaper industry saw a dramatic decline, and companies like Tribune Co. and McClatchy filed for bankruptcy, leaving investors with massive losses.
Finally, the regulatory environment can change in ways that disproportionately affect cyclical industries. Tariffs, environmental regulations, and labor laws can have substantial impacts. For example, the imposition of tariffs on steel imports by the U.S. government in 2018 led to increased costs for domestic automakers, which in turn affected their profitability and stock prices.
So, what makes these stocks alluring despite all these risks? The potential for high returns during economic expansions is too tempting for many to ignore. However, balancing the allure with the inherent risks makes a well-diversified portfolio essential. If you decide to dive into cyclical stocks, arming yourself with thorough research and a solid risk management strategy is crucial. The element of unpredictability calls for a cautious yet opportunistic approach.
For more information on cyclical stocks, check out this link: Cyclical Stocks.