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What Is A Counter-Cyclical Stock?
A Counter-Cyclical stock refers to the securities of those firms whose financial performance is inversely related to the state of the economy. Hence, these stocks trigger share prices to rise during an economic recession. It aims to diversify investment portfolios, provide stability amidst economic downturns, and act as recession insurance for investors.
Suck stocks are basically related to healthcare, consumer eatables, and utilities. Investors can use these to reduce the risk related to their portfolios and may also generate profits during hardships in the economy. Traders may use these to hedge against market volatility. These stocks may underperform when the economy starts to expand.
Key Takeaways
- A counter-cyclical stock is one whose financial performance is adversely correlated with the status of the economy and drives share values up during recessions.
- It seeks to diversify investment portfolios, offer stability during economic downturns, and serve as investors' recession insurance.
- These carry risks such as market volatility, government policy dependency, cautious investment approach, bankruptcy risk, identification challenges, and a fallible prediction of market bottom, making them difficult to invest in during economic recessions.
- Moreover, it fluctuates with market trends, while countercyclical stocks maintain stability regardless of market fluctuations, exhibiting contrasting volatility levels.
Counter-Cyclical Stock Explained
Counter-cyclical stocks are those stocks that perform well, irrespective of economic downturns. As such, it is advisable to add these to the investment portfolio to sustain the equity exposure and reduce the downturn risk while the economy faces recession. However, these stock prices may decline in small margins in case of a significant market collapse in relation to cyclical stocks.
It works only during economic expansion due to specific company policies or specialized situations like inflation. In these situations, jobs become scanty, wages saturate, and consumers have decreased disposable income. As a result, they are forced to reduce their non-essential expenditures like buying cars, booking holiday vacations, new house purchases, and going to discount retailers to shop.
Consequently, demand for companies manufacturing these products or offering such services experienced increased demand irrespective of the slowing economy. Hence, companies offering cheap products or services tend to perform well during an economic slowdown, recession, or inflation. Consequently, their stock prices rise or show little to no effect on their stock value. Investors use this feature to diversify their portfolios and get a stable source of income. They can also hedge against market volatility risk.
Nevertheless, countercyclical stocks entail risks also due to the unpredictable and complex nature of the markets. It happens because market growth does not necessarily mean growth in stock markets. Furthermore, these stocks can also suffer during economic expansion. Hence, investors may face risk in their investments when the market expands. One can find these stocks for companies in essential goods and services, utilities, petroleum, and staples.
Thus, before making any financial decisions, including purchasing countercyclical equities, careful investigation and analysis are crucial. Examining the business's financial records, examining market patterns, and taking the political and economic climate into account are a few examples of research.
Example
Let us assume that an investor from the Newfield area, Alex, decided to invest in the stock markets. Hence, she invested ten thousand dollars each in buying the shares of Zigmatic Tech (ZPT) and Stellaric Agro (STP). Here, Stellaric Agro was a countercyclical firm that grew to twenty thousand dollars during inflation. On the other hand, Zigmatic tech lost in value to eight thousand during the same period and condition.
Her portfolio stood at twenty-eight thousand during the recession. Therefore, her wise decision to invest in Stellaric Agro saved her from major losses, and she was able to gain eight thousand dollars over her total investment of $20,000.
Risks
Although beneficial during economic turmoil or inflation, these stocks tend to carry certain risks, as mentioned below:
- Market Volatility Impact: The stock markets are highly unpredictable and tend to impact these stocks as well. Hence, even the most demanded stock under it may experience a decline in demand for their products or services.
- Government Policy Dependency: Sectors and companies falling under this category are highly dependent on government policies, so any alteration in government policies or rates affects their performance negatively. So, it may lead to loss to the investor.
- Cautious Investment Approach: It may not be correct to assume that all companies under the counter-cyclical category may perform positively during economic recessions. Hence, holistic research must be carried out before investing.
- Bankruptcy risk: Companies not having financial resilience may go bankrupt, eroding investors' funds.
- Identification challenges: It becomes difficult to identify the correct sector or company as counter-cyclical due to their evolving nature.
- Fallible prediction of market bottom: Many times, investors fail to predict the bottom line of the business cycle at the correct time. Hence, it may lead to loss if invested at the wrong time in these stocks.
Cyclical vs Counter-Cyclical Stocks
Both are integral aspects of share pricing of companies in a stock market, but they have differences, as shown below:
| Cyclical stocks | Counter-Cyclical Stocks | |
|---|---|---|
| Cyclical stocks tend to be volatile and change their value as per trends in the market. | These stocks are non-volatile and remain steady in value during all market situations. | |
| They become underperforming during an economic recession. | They tend to outperform during the recession. They perform well during economic growth and expansion. | . |
| Companies selling goods and services, except staples, household goods, and healthcare, fall into this category. | Hence, companies selling staples, household goods, and healthcare fall into this category. | |
| Here, the companies produce goods and services that consumers buy when they get disposable income. | These companies produce goods and services that consumers buy when they face a shortage of income. | |
| They are related to companies producing luxurious goods. | These are related to companies producing goods for daily needs. |
Frequently Asked Questions (FAQs)
These stocks have the following benefits:
- They provide diversification to an investor's investment portfolio.
- These give steady returns even during the economic downturn.
- Moreover, they have good growth potential during economic expansion.
- Therefore, these are helpful to consumers in surviving inflation.
- Sectors active here tend to be evergreen in growth and returns.
Although it is challenging to recognize stocks falling in this category, by carefully analyzing the stock price movement of stocks during recession and growth, one can identify the stocks. If the stocks perform strongly during the recession and fail to do so during expansion, then it signals that they are countercyclical stocks.
Indeed, a lot of stocks that are countercyclical pay dividends. They are frequently regarded for their dividend stability, which offers investors a possible stream of income, particularly in recessions when capital gains may be restricted.
