What are cyclical stocks? Discover the answer, plus how these types of stocks best fit into your portfolio

What are cyclical stocks? Cyclical stocks have regular rises and falls in price, usually tied to business or economic cycles. When times are good, investors in cyclical stocks sometimes ignore investment drawbacks and pitfalls. When times are bad, many investors pay too much attention to risk.

Test your knowledge of cyclical stocks by answering the questions below:

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A: What are cyclical stocks in terms of sectors?

1. Resource stocks
2. Consumer stocks
3. Utility stocks
4. None of the above

You are correct if you answered 1.

Cyclical sectors like resource and energy stocks are subject to wide and unpredictable swings. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up.

This expands profits at resource companies. But when the economy slumps, commodity prices fall, and this drags down profits and stock prices. This highly cyclical sector has gone through many booms and busts.

B: Generally speaking, the resource sector has:

1. A low level of volatility
2. Average volatility
3. Above average volatility
4. No volatility at all

You are correct if you answered 3.

Generally speaking, stocks in the Resources & Commodities sector, as well as the Manufacturing & Industry sector, expose you to above-average volatility. Those in the Canadian Finance and Utilities sectors involve below-average volatility, while Consumer stocks are in the middle.

In addition to rising and falling with the business cycle, however, resource stocks have a history of rising along with long-term inflationary trends. This gives them a rare ability: they provide a hedge against inflation.

You may feel resource stocks could languish for years. You may think it’s best to stay out of them until inflation moves up. But these stocks could give us an early warning of coming inflation. They may shoot up long before inflation revives.

C: The best time to buy cyclical stocks is typically:

1. When the stock’s historical P/E range is lower than the average
2. When the stock’s historical P/E range is in the middle
3. When the stock’s historical P/E range is slightly higher than the average
4. There is no best time to buy consumer cyclical stocks

You are correct if you answered 2.

It’s far better to buy cyclical stocks when their P/Es are in the middle of the historical range—neither too high nor too low. If the P/E is too low, it could mean that the earnings are at a cyclical high and they will soon drop, along with the share price. On the other hand, sky-high P/Es can result when earnings collapse. That means that the numerator, the price, remains high, while the denominator has fallen. The problem here is that the share price may retreat before earnings rebound.

All in all, it’s best to buy cyclicals when earnings are steady and P/Es are neither too high nor too low. That’s when buyers will likely get the most value with the least amount of risk.

P/E (price to earnings) ratios—the ratio of a stock’s price to its per-share earnings—are published regularly in newspapers and on the Internet. These financial ratios are widely followed, and are an important part of many investors’ decision making.

Note, though, that by themselves, P/Es can steer you wrong on individual stocks, and on the market in general. There are lots of stocks out there that are cheap on a P/E basis. But many will remain cheap—their share prices won’t be rising any time soon.

D: Stock market cycles occur:

1. Sometimes
2. Rarely
3. Once every 20 years
4. Repeatedly

You are correct if you answered 4.

Stock market cycles occur repeatedly—and there are any number of theories as to which sectors will outperform at any given short-term stage of the cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. That’s because to succeed, you need to guess right twice. You have to pick the top sectors, and then pick the stocks to rise within those sectors. Consistently succeeding at both is extremely difficult.

E: Dividends from cyclical stocks are:

1. Less predictable
2. Non-existent
3. Being paid more than other sectors
4. None of the above

You are correct if you answered: 1.

Dividends from companies in cyclical industries, whose profits move up and down with the overall economy, tend to be less predictable than payments from more-stable businesses such as utilities. However, the best opportunities will come from stocks that have a long history of maintaining their dividend payments, or even raising them, during economic downturns.

What are the best cyclical stocks to buy? For advice on when to buy resource and other cyclical stocks, follow TSI Network and use our three-part Successful Investor strategy:

1. Invest mainly in well-established, dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

The effectiveness and the predictive ability of cyclical stocks can be controversial. How do you decide on investing in cyclical stocks?