Cyclical vs. Defensive Stocks
It’s no secret that consumers are the driving force behind the U.S. economy; consumer spending is responsible for more than two-thirds of U.S. gross domestic product (GDP).1
Even though real GDP increased at an unimpressive rate of 2.4% for all of 2014, consumer spending in the fourth quarter grew at the fastest pace in more than eight years.2 In January 2015, the Consumer Confidence Index followed suit and surged to its highest level since before the Great Recession hit in 2007.3
A stronger job market and lower gas prices, which left many consumers with a little extra money in their wallets, contributed to the fourth-quarter spending spree.4
But will U.S. consumers help shift the economy into higher gear in 2015? The answer will most likely depend on whether the average American’s financial prospects continue to improve.
Here’s a closer look at how consumer spending and economic growth may affect various sectors of the stock market.
Riding the Economy
The stocks of companies that primarily offer non-essential goods and services are generally referred to as “cyclical.” When times are tough, consumers often forgo spending on luxuries and delay big-ticket purchases they can live without.
The consumer discretionary sector is considered cyclical in nature; it includes industries such as retail, financial services, travel, and apparel that tend to benefit from growing consumer demand. Durable goods manufacturers (automobiles and appliances), home builders, and technology companies are also part of the cyclical category.
Cyclical stocks are “economically sensitive,” which means their share prices typically fall during recessions and rise as employment, consumer spending, and economic activity improve.
“Defensive” (non-cyclical) stocks are less affected by economic changes, because these companies produce goods and services that people typically continue to buy no matter what. Examples of defensive sectors include consumer staples (which includes food, beverages, and household necessities such as toilet paper), utilities (water, gas, and electric), and health care.
The share prices of defensive stocks tend to hold up better during periods of economic uncertainty and financial market turbulence. On the other hand, companies in defensive sectors often carry higher amounts of debt, in which case their share prices or dividends might be negatively affected by a rise in interest rates.
Cyclical and defensive stocks tend to outperform during different stages of the business cycle. But keep in mind that every cycle is different from the last, and macroeconomic events or unexpected geopolitical shocks can sometimes disrupt regular trends. In most cases, it is difficult to recognize turning points until after they have passed.
Investors who “chase performance” and move assets into hot sectors may be too late to benefit from market gains and could suffer losses instead. Investing in an appropriate balance of cyclical and defensive shares may help increase return potential, smooth volatility, and moderate risk in your equity portfolio.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Past performance is no guarantee of future results. A portfolio invested only in companies in a particular industry or market sector may not be sufficiently diversified and could be subject to a significant level of volatility and risk.