Understanding the differences between cyclical and defensive stocks can be advantageous to an investor. There will be times where share markets tend to rotate from one sector to another. Being able to identify the differences between a cyclical and defensive could make a difference in the performance of the portfolio.
Definitions of cyclical stocks and defensive stocks
Cyclical stocks are stocks which have stock price performances linked to the economic environment. When the economy is doing well then cyclical stocks do well. Sectors which can be classified as cyclical stocks are consumer discretionary goods, basic materials, financial services, and real estate. Consumers are more willing to buy products and services that they want but don’t need when the economy is healthy. This is why consumer discretionary companies do well when the economy is booming. For instance, retail, travel, restaurant companies are high in demand when consumers feel secure about the economic future. They are more likely to spend money on apparel and go out to restaurants when they aren’t concerned about a recession looming.
Stocks in the basic materials sector are cyclical as mining is high in demand when the economy is strong. This is because resources are needed to build products. The manufacturing sector also does well when there is economic growth as there is a demand for manufacturer goods from consumers.
Stocks in the financial services are considered cyclical stocks as demand for loans increase when consumers feel confident about the future. People are less likely to want to take out a home loan if they think there is a recession coming and there is a possibility they may lose their jobs. However, when the economy is strong, companies are more likely to expand businesses and take out loans to grow operations.
Defensive stocks are companies that are in demand regardless of what is happening in the economy. Such sectors include consumer staples, utilities, healthcare, and communications. These companies offer goods and services which are essential services. So when the economy is weak, demand for these is still consistent. For instance, consumers still need to buy groceries when there is a recession, the demand does not decrease because the economy has weakened. People still need access to utilities so these companies still maintain a steady stream of revenue when the economic growth is poor. Healthcare companies are considered defensive stocks as people will still need to access healthcare when the economy is in a recession.
When is the best time to buy cyclical and defensive stocks?
Cyclical stocks perform well when the economy is growing. Investors will sell out of defensive positions as cyclical stocks perform better when economy start to strengthen.
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Defensive stocks do well when the economy is weak or when it is in a recession. Investors like to rotate out of cyclical stocks and into defensive stocks during these uncertain economic periods as they are looking for safe havens. As these companies still earn revenue during bleak times, the demand for defensive stocks is higher than cyclical stocks. Defensive stocks tend to be the poorest performers when the economy is strong.
Lauren Hua is a private client adviser at Fairmont Equities.
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