How do you take advantage of the economic cycle through investing?

There are a few ways, but one is to invest in cyclical and consumer discretionary stocks. The performance of these companies is tied closely to the performance of the economy.

When consumers have extra money to spend on non-essential items, they should do well. But when consumer's budgets are constricted, these companies also tend to be some of the first to take a hit.

In this article, we'll look at the pros and cons of cyclical and consumer discretionary stocks. We'll also explain the best ways to invest in them. Here's what you need to know.

Understanding The Economic Cycle

Cyclical and consumer discretionary stocks closely follow the economic cycle. So it's important to understand what this cycle is and how it works before we talk about these two groups of stocks.

The economic cycle is often described as having "boom and bust" periods, however the "booms" and "busts" can be very subtle. There are four main segments of the economic cycle as shown below. Note that while ever cycle will run through the below stages, no one phase is necessarily considered "first."

• Trough
• Expansion
• Peak
• Contraction

Troughs are often referred to as recessions. This is when the economy has turned down, people are being laid off, consumers aren't spending as much, and some businesses are closing. Times can be difficult during a recession.

Expansion means the economy is coming out of a recession. Things are looking up. People are being hired again, businesses are expanding and investing in capital expenditures (i.e., CapEx), and consumers are starting to spend more.

Eventually, expansion will lead to overheating and the economic cycle will hit its peak. At the peak, consumers are spending as much as they can, employment has reached its zenith, and prices have increased due to demand.

At the peak, high prices will cause consumers to pull back on spending. As spending slows, businesses lower prices, compressing profit margins. In turn, companies look for ways to cut costs, which often leads to layoffs. Now the economy is in contraction. If sustained, the economy will enter a new recession (i.e. trough). And thus the cycle begins again.

What Are Cyclical And Consumer Discretionary Stocks?

The ability for consumers to spend on non-essential products is called discretionary income. This should not be confused the with the discretionary income that is used to calculate payments on an income-driven student loan repayment plan. In this case, we're referring to the income that a consumer has left over after they've covered all the essentials such as food, rent, electricity, and local travel.

Cyclical stocks follow the economic cycle described above because they produce non-essential (or non-durable) products. While the economy is expanding and consumers have discretionary income to spend, they’ll buy non-essential products. But once the economy begins contracting, consumers will spend less on these items, maybe even cutting them out entirely.

Cyclical Sectors

Some examples of cyclicals include:

The above sectors generally perform well during a growing economy (i.e., expansion). But as it cools, consumer spending will shift towards less economically-sensitive sectors. This is called sector rotation.

As the economy emerges from a recession, one sector that performs well is financials, including banks, brokers, and insurance companies. Eventually, non-essentials start performing well too and will ride the expansion phase up.

Non-Cyclical Sectors

While cyclical stocks can perform well during during expansion phases, non-cyclical stocks are a safer bet during economic downturns as their revenue streams are more "recession-proof."

Less economically-sensitive sectors include the following:

These sectors may also go by other names such as "consumer staples" or "defensive" sectors. 

Examples Of Cyclical Stocks

With an understanding of what cyclical and consumer discretionary stocks are, let’s look at a few examples. Here are a few well-known cyclical stocks:

• Amazon (AMZN) — Internet direct marketing retail
• Tesla (TSLA) — Automobiles
• Home Depot (HD) — Specialty retail
• McDonald’s (MCD) — Hotels, restaurants, & leisure
• Marriott (MAR) — Hotels, restaurants, & leisure
• Starbucks (SBUX) — Hotels, restaurants, & leisure
• Las Vegas Sands (LVS) — Hotels, restaurants, & leisure
• Nike (NKE) — Apparel & luxury goods
• DR Horton Inc (DHI) — New home construction
• Wayfair - Furniture and decor

It should be noted that some of the company's listed above are less cyclical than others. For example, while Amazon is one of the world's largest online sellers of non-essential goods, it now also sells household items and, in most areas, even groceries. This growth into essential products will make Amazon less cyclical than, say, an online furniture retailer like Wayfair. 

How To Invest In Cyclical And Consumer Discretionary Stocks

Do you anticipate that the economy will enter, or remain, in a growth phase of the economic cycle for the foreseeable future? If so, investing in cyclical stocks during the expansion could provide an out-sized return vs consumer staples that tend to grow at a slower and more stable pace. 

While you could go through the above list of cyclical stocks, researching each to see which one presents the best value, there’s an easier way to gain exposure to cyclical and consumer discretionary stocks. That’s by investing an ETF that focuses on them.

XLY (Consumer Discretionary Select Sector SPDR Fund), for example, is weighted heavily to consumer cyclicals (94.10%). Here are a few more popular ETFs that invest in cyclical and consumer discretionary stocks:

• Vanguard Consumer Discretionary ETF (VCR)
• Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RCD)
• Fidelity® MSCI Consumer Discretionary Index ETF (FDIS)
• First Trust Consumer Discretionary AlphaDEX® ETF (FXD)
• SPDR® S&P Homebuilders ETF (XHB)
• SPDR® S&P Retail ETF (XRT)

Keep in mind that you'll pay a small fee to hold ETFs (called the fund's expense ratio). Also, if you already own some of the individual stocks in the ETF, buying shares of the fund will increase your exposure to those individual names.

Most of the top stock brokers will allow you to invest any of the above ETFs without having to pay any trade commissions. You can compare online stock brokers here >>

Final Thoughts

For those who stay on top of the economy's pulse, investing in cyclical and consumer discretionary stocks can be a smart way to grow their portfolio in tandem with the overall economy. Just remember that while these groups should do well during the expansion phase of an economic cycle, they'll be under-performers during the contraction phase.