Throughout economic cycles, some industries outperform others as their pattern is better aligned with the current growth environment. Two growth patterns are differentiated, cyclical and secular trends.
Understanding the differences between cyclicals and seculars is critical for investors to analyze financial markets, understand corporate profitability models, and develop forecasts. They are closely integrated with fundamental company analysis and shape asset allocation decisions.
By definition, “cyclical events happen in a particular order, one following the other, and are often repeated”.
A cyclical stock is one whose price is correlated to macroeconomic or systematic changes in the economy. In other words, it moves with the economy’s cycle fluctuations. These stocks are known to be more market-sensitive than others, showing significant gains when the economy is booming and more considerable losses in a recession. Companies that rely heavily on consumer disposable income generally fall into the cyclical category.
For instance, some industries were significantly more affected than others during the Covid-19 pandemic, including airlines, hospitality, and entertainment. These are therefore considered to be cyclical stocks/industries. Identifying the cyclicality of a company can assist with determining its earnings curve.
Accor SA (EPA:AC) Stock Price
As shown in the graph above, the hotel industry is cyclical as it is heavily correlated with market movements. Specifically, it relies on consumers’ ability to spend, which was substantially curtailed during the 2008 crisis (or during the Covid-19 pandemic), and this is reflected in the stock price.
As a result, cyclical stocks are considered as higher-upside products – consumer buying power is higher in times of economic growth, which leads to higher earnings and, in turn, higher stock prices. Gains and losses are tenfold. Hence, risk-averse investors can significantly benefit from these stocks when they are timed correctly, as they often outperform the broader market during periods of strong growth. Likewise, although market timing is a debatable topic, cyclical stocks can help predict the current market cycle and support the asset allocation process.
Nevertheless, they also carry a high degree of risk, as they correlate to sectors subject to strong fluctuations throughout economic cycles.
On the other hand, secular trends continue moving in the same direction over the long term, regardless of present economic conditions. Secular trends are driven by fundamental changes in the economy, such as changes in consumer behavior, demographic shifts, or the advent of new technologies.
A secular stock is therefore defined as a position whose performance is largely unaffected by short-term economic trends. Food and beverage, household products, or the tobacco industries are, for instance, known to have followed secular patterns since demand remained consistent throughout cycles.
It is also important to note that secular trends can be positive or negative. When interest rates are low, corporate profits are high, and stock values are rising, secular markets are referred to as secular bull markets. When such a climate prevails, secular values are bound to rise steadily, as the market reflects investor confidence and indicates strong economic growth and market strength.
On the other hand, when the economy is sluggish, corporate earnings are down, and market pressure is increasing, investors refer to a secular bear market. Marked by uncertainty and market downturn, secular values are expected to follow a constant downward trend in such a market scenario.
Google Alphabet Inc. (GOOGL) Stock Price
Technology and some underlying industries, such as cloud computing, are also considered to follow secular patterns. Google’s growth, as depicted above, has been following such pattern, driven by the advent of new technologies and changes in consumer behavior since the inception of the Internet.
Similarly, it is acknowledged that cloud computing has greatly restructured the processes that individuals and businesses rely on today, as further emphasized by the Covid-19 pandemic. As such, underlying companies have experienced secular growth.
Identifying secular stocks trends can be more challenging than cyclicals as these industries are driven by many external factors, such as innovation, new markets and products, and changing consumer behavior. Furthermore, these factors are not constant; they can fluctuate substantially over time, thus breaking a heretofore secular trend.
In the current context
Secular stocks underperformed cyclical stocks last year. This stands to reason since the recovery has been strong, and cyclical stocks are more responsive to fluctuations in GDP. As such, to take advantage of the rebound, investors have mostly shifted to cyclicals.
However, 2022 has gotten off to a poor start, with significant inflationary pressure and considerable volatility, leaving cyclical equities vulnerable again.
Therefore, secular stocks are often viewed as a better option from a long-term strategy standpoint. Portfolios with secular growth exposure tend to have lower overall risk and volatility while delivering attractive returns over time.
The bottom line
As described, cyclical and secular stocks differ in many ways. Investors require a thorough understanding of market cycles and current growth components to take advantage of them.
Seculars are often preferred for a long-term holding strategy, while seculars can provide tenfold returns when the economy is booming. Investors should gauge their risk tolerance when investing in long-term cyclical stocks, as they often decline sharply during economic downturns.
Once these characteristics are known, risk tolerance will primarily guide investors’ allocation decisions.
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