How do economic cycles work
Trying to predict the value of the markets is a bit like driving at 100 km/h on a foggy road, however, we are all aware that the economy, like anything else, has good and bad times. During difficult times, unemployment rises, GDP decreases and the stock market falls. In addition, the coronavirus pandemic has taught us that difficult times do not affect all businesses equally.
Can we predict which companies will be affected?
The truth is that it is impossible to know with absolute certainty, but there are sectors of the economy that tend to be less vulnerable to economic fluctuations. This is why there is a distinction between cyclical stocks and defensive stocks. Let's take a closer look.
Understanding Business Cycles
The first thing to know is that the Capitalist or Free Market Economy operates in cycles, going from growth to recession, then recovery, and so on. Ideally, in the long run, the overall trend is upward, and the economy grows. Many economists have developed theories about exactly how these cycles unfold, and their names and definitions can vary widely, but generally four phases are recognized in the business cycle: two phases of growth - recovery and expansion - and two phases of contraction - recession and depression.
During the period of recovery and expansion, the country's GDP increases, and inflation intensifies. To control this inflation (the gradual increase in prices affecting almost every good you buy), interest rates also rise. Consumer spending, both at the export and import levels, increases, leading to higher production and investment.
When the economy reaches its peak or maximum expansion, it reaches a level of overproduction and market saturation, resulting in lower sales. This marks the beginning of a recession that can turn into a depression. Unemployment rises, GDP falls, as does inflation or, in many cases, deflation (when commodity prices fall over time). In this case, central banks usually lower interest rates to stimulate consumer spending.
Cyclical vs. Defensive Stocks
Now that you understand what economic cycles are, it's time to introduce you to cyclical stocks!
As mentioned earlier, some sectors are more sensitive to different phases of economic cycles. Cyclical stocks are those that thrive when the economy is growing and suffer during periods of contraction.
Car manufacturers and technology companies are good examples. The same applies to tourism-related sectors, such as hotels or transportation, as well as furniture manufacturers. These sectors essentially produce goods that we buy when we have extra money, but that are not essential to our daily lives.
At the other end of the spectrum are defensive stocks, often seen as recession resistant. These are companies that produce goods that are always consumed, regardless of the state of the economy, such as food or pharmaceuticals. They maintain more or less a stable growth.