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Cyclical vs. NonCyclical Stocks

Cyclical vs. NonCyclical Stocks
We cannot control the cycles of the economy but we can adjust our trading to the cycle. Adjusting to economic transitions requires an understanding of how each industry develops in their relationship to the economy. It is important for us to know the difference between cyclical and noncyclical companies so that we can distinguish between the sectors that are affected by economic changes and those that are more defensive in nature. Tonight we will look at the industries within these two categories and identify where we can trade both long and short to take advantage of this economic swing in the cycle. If the economy starts to decline we certainly can profit by shorting the cyclical stocks.  Remember the stock market has the uncanny ability to forecast the economy six months out.  By the looks of some of the cyclical stocks on our bulletin short watch list the economy is headed for a fall.  We have advanced notice of this just by the way these cyclical stocks are acting right now. 

Economic Slowdown
Noncyclical stocks repeatedly outperform the market when economic growth slows while cyclical companies are highly correlated to the economy. The noncyclical companies also called defensive stocks will profit regardless of economic gyrations because they produce or distribute goods and services that we always need: food power water and so on. The sales of companies with cyclical products on the other hand depend on whether or not the economy is strong; sales will thrive when people have extra income to spend on luxuries and they will decline when the economy slumps.  If you believe the Federal Reserve is on a mission to slow down the economy then defensive stocks are where you should have your money and you should be shorting the cyclical stocks.  

The difference between cyclical and noncyclical industries is simply the difference between necessity and luxury. There are certain items we cannot live without and would not cut back on even when times are tough. The stocks of companies producing these items are noncyclical and are not hurt by the effects of an economic downturn. 

Cyclical items are new cars fancy restaurants high end jewelry boats RV's and the travel industry (cruise lines casinos airlines hotels). These are the sectors that produce things we can live without when money is tight.  Other examples of cyclical industries are manufacturing and construction. These are the types of industries and stocks that you want to avoid being long when the economy slows.  More aggressive traders would short these stocks during this slow period. 

An excellent example of a noncyclical industry is utilities.  These stocks can help investors avoid losses when highly cyclical stocks are getting crushed.  For instance a well timed rotation out of CAT and into a utility stock is the type of maneuver that the smart money has used for years during economic downturns. If times get tough new money for building projects slow and therefore construction companies would not purchase heavy machinery. But no matter what our top priority will always be to have power and heat for our homes. By providing a service that is consistently used utility companies grow conservatively and do not fluctuate dramatically.  However this safety is a slow return on your money and when the economy sees some growth again these stocks will lag immensely. 

Companies such as PG CLX MO and G are all attractive investment choices when the economy is in the dumps.  Remember you pay for safety in that the stocks are slow movers but at least they would not fall off the cliff as some cyclical stocks are doing now and while you wait for the market to turn around you collect a nice dividend. 

Predicting economic cycles is not within the scope of this service but realizing that different industries respond differently to economic fluctuations can help us stay on the right side of the trade.  When the economy cools off the cyclical companies will be hit the hardest those are the ones we have been exploiting and taking short positions in.  If you cannot short stocks you should try to find the stable companies that produce things you cannot live without. Those stocks should hold up during a bear market.

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