A guide to exploring cyclical stocks
Editorial staff, J.P. Morgan Wealth Management
- Cyclical stock performance is tied to the economy’s performance. Cyclical stocks will typically outperform when the economy is booming and underperform when it is not.
- The four market phases are accumulation, mark-up, distribution and mark-down.
- Although investors can potentially generate profits by buying cyclical stocks in the accumulation phase and selling in the distribution phase, anticipating market phases can be risky.
- Your approach to cyclical stocks depends on your investment plan and long-term goals.
One of investing’s tried-and-true strategies is known as “buy-and-hold.” Basically, you buy stocks and hold them for a long time. This strategy historically works because “timing” the market is risky and often leads to missed opportunities, while a buy-and-hold strategy helps you avoid costly spur-of-the-moment decisions.
That said, there may still be a way to incorporate stocks that you believe can optimize your portfolio’s performance over the medium term. One method involves determining the current market cycle and then integrating into your portfolio stocks, exchange-traded funds (ETFs) or mutual funds from a sector that tends to perform well in that cycle.
Before you make any investment decisions, you should consider consulting a financial advisor to make sure your investment strategy aligns with your long-term goals and risk tolerance.
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What are cyclical stocks?
At this point, you’re probably wondering why we are holding out on cyclical stocks and market phases. But before we delve into market cycles, it’s important to understand what cyclical stocks are.
Cyclical stocks are those that are directly affected by the ups and downs of the economy. They will outperform the broader market when the economy is booming and underperform when it is not. That’s because they are dependent on the purchasing power of the consumer. So, when the economy is strong, consumers will purchase goods in these sectors, but when the economy is struggling, consumers will cut back on their spending in this space.
For example, shares of companies in the consumer discretionary sector would be classified as cyclical stocks. These companies produce goods that people buy with their “discretionary” income, which is the money that remains after all necessary expenses and taxes have been accounted for. Think automobile companies, fashion brands, restaurant franchises and the like. It stands to reason then that people would be more inclined to purchase non-essential goods if they have the additional income to do so. Other examples of sectors that are cyclical include entertainment (like streaming services and gaming companies) and travel (like airlines and resorts).
The connection between cyclical stocks and market phases
Cyclical stocks are usually quite sensitive to the different phases that an economy goes through, and this is reflected in the volatility of their stock prices. Healthy economies cycle through expansions and recessions as they rise and fall between these extremes.
This carries over to the stock market, where trends called “market phases” emerge. There is no defined time frame for each phase: It could be weeks, months or longer. This is a big part of why attempting to time the market is risky and often does not yield the desired result. The key for investors is finding sectors that are well-positioned for the current market phase and seeking exposure through a mix of stocks, ETFs and mutual funds. Since accurately anticipating a change in market phase is unlikely, it is important to find balance both in the sectors of cyclical stocks you may choose to invest in as well as in the range of specific companies within those sectors. It’s important to note that while diversification may help reduce risk, it does not guarantee a profit or protect against loss.
But before you make any investment decisions, consult with a financial advisor to see what the best path forward is for you. And remember, trying to time investments based on when a recession may or may not come can be damaging to long-term returns. Historical data indicate that within a one-year timespan, stock returns ranged from up +52% to down -37%, while a 10-year hold yielded a less variable range of up +20% to down -1%. A 20-year hold saw a solely positive range from up +18% to up +6%. While being on the sidelines during the worst months can seem like the safer option, losing out on long-term gains can be costly.
What are the main market phases?
Stock market researchers have spent a lot of time trying to identify the different phases a market experiences, and there is much variance in their results. Part of this is because these phases are fluid and cannot be outlined definitively. However, most agree that the market can be broken down into four major phases that align with the stages in an economic cycle.
- Accumulation. This stage begins after the stock market has bottomed out and correlates to the economy being in the latter stages of a recession. There typically isn’t much upward movement in the market, but a downward trend has stalled. Economic indicators will still show that the economy is in a recession. However, skilled investors often strive to take advantage of depressed prices to start buying stocks of companies they believe are well-positioned to outperform the broader market when economic growth starts to pick up steam. This results in market stabilization.
- Mark-up. During the mark-up phase, investors can feel emboldened to enter the market as economic indicators show an economy on the path to recovery. Stock valuations start to rise, and investors’ continued participation often spurs further market acceleration.
- Distribution. This phase is defined by conflicting investor views. On one side, you have investors who hope that stock prices continue to rise even though market valuations are stretched. On the other side are investors who, citing the same data, think that a market correction is overdue. The bull market stalls, and investors worry about the possibility of the next market phase. It is at this stage that an external event, such as war, might be the catalyst that leads to the next market phase.
- Mark-down. This is the phase that investors often instinctively want to avoid. However, the traditional buy-and-hold investor will typically weather the storm, knowing that even with downturns markets historically trend up over the long-term. Nonetheless, as markets begin to decline, investor selling tends to gain momentum. This is the final phase, and it is both potentially painful to the average investor and necessary for the functioning of a healthy market. The bright side is that history shows markets usually rise over time, despite the intermediate drops along the way.
How cyclical stock investors use market phases
Market phases are thought to precede the beginning and end of each stage of the economic cycle. From a cyclical stock point of view, the four market phases can be divided into two sections: when investors tend to buy and when they’re more likely to sell cyclical stocks. Based on the descriptions above, an experienced investor typically looks to buy cyclical stocks in the accumulation and mark-up phases and sell in the distribution and mark-down phases.
Having an understanding of the market phases does not mitigate the risks that come with attempting to time the market. The best strategy for you will depend on your overall investment plan, goals and risk tolerance. In general, resisting the urge to time the market and react during a market downturn is often a safer bet. It is a good idea to consult a financial advisor before making any changes to your investment portfolio.
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Editorial staff, J.P. Morgan Wealth Management
