Cyclical vs Defensive Stocks: Market Cycles Explained

Hello, I am CA Sandeep Kumar, and today’s topic is Market Cycles. 

In this video, we will discuss business cycles versus market cycles, expansion, slowdown and recovery, cyclical versus defensive sectors, commodity cycles, credit cycles, earnings cycles, peak-cycle profits and why a low P/E ratio can sometimes be misleading. So, let's begin. 

Even a great company can become a poor investment if it is bought at the wrong phase of a cycle. And sometimes, entering the right phase of a cycle can significantly influence the investment outcome.  Markets and economies do not move in straight lines. Growth accelerates, then slows down, and eventually recovery can follow. Investor behaviour often follows a similar pattern. Strong conditions create optimism. Excessive optimism can turn into euphoria. And when the cycle reverses, fear and pessimism may begin to dominate. 

This is why investors can sometimes become aggressive buyers near market peaks and increasingly cautious near market bottoms. The objective of this video is not to predict market tops or bottoms. The objective is to understand which phase of the cycle the economy, industry, and business may currently be passing through. Because investment outcomes are influenced not only by the quality of a company, but also by the cycle surrounding it. 

Business Cycle vs Market Cycle 

Let us first understand the difference between the business cycle and the market cycle. The business cycle reflects the overall health of the economy and generally passes through four broad phases. 

Expansion

During expansion, economic growth is strong. Demand improves and corporate profits generally increase. 

Slowdown

During a slowdown, growth begins to moderate. Demand and profit growth may gradually weaken. 

Contraction 

During contraction, economic activity becomes weaker. Corporate earnings may decline and overall sentiment generally deteriorates. 

Recovery 

During recovery, demand and earnings begin to stabilise. Confidence improves and economic growth can gradually start picking up again. 

Interestingly, opportunities can sometimes begin emerging during the recovery phase when fundamentals are improving but sentiment is still weak. This leads us to the concept of the market cycle. 

What Is a Market Cycle? 

An important concept in investing is that the stock market and the economy do not always move together. 

Why? Because markets are forward-looking. 

They attempt to price future expectations rather than only present economic conditions.This means markets can sometimes rally even when current economic conditions remain weak. Similarly, markets can correct even when current economic data appears strong. 

Understanding this difference is important when analysing market cycles. Broadly, market sentiment may move through phases such as pessimism, recovery, optimism and euphoria. 

Pessimism 

Pessimism is generally the weakest sentiment phase of the cycle. News flow becomes negative. Investor confidence is low. Valuations may also become depressed. Many investors may prefer to stay away from equities. However, future opportunities can sometimes begin developing during this phase because expectations are already very low. 

Recovery 

Next comes the recovery phase. Business conditions begin improving. Earnings can start stabilising and confidence gradually returns. Markets often begin moving before the improvement becomes obvious to everyone. However, many investors may still remain sceptical because memories of the recent downturn are still fresh. 

Optimism 

As the recovery strengthens, economic activity and earnings can improve further. Investor participation increases. Confidence improves. Valuations may also start expanding. This phase often feels increasingly comfortable. However, investors should remember: 

Investment comfort and investment opportunity are not always the same thing. 

Euphoria 

The next phase is euphoria. This can be one of the riskier phases of the market cycle. Investor confidence becomes extremely high. Valuations may become stretched and risks can start getting ignored. Investors may stop questioning whether current growth rates are sustainable and begin assuming that favourable conditions will continue indefinitely. This is why understanding where expectations stand in the cycle is important. 

Cyclical vs Defensive Sectors 

Different sectors do not respond to the business cycle in the same way. Cyclical sectors are closely linked to economic growth. Examples include automobiles, metals, cement, real estate and capital goods. When the economy is strong, demand and earnings in these sectors can accelerate. 

But during an economic slowdown, their profitability can also be affected significantly. Defensive sectors generally experience relatively more stable demand across economic cycles. Examples include FMCG, healthcare and utilities. 

Demand for many of these products and services may remain relatively stable even during an economic slowdown. As a result, earnings can sometimes be more predictable than those of cyclical sectors. Market leadership can therefore rotate between cyclical and defensive sectors depending on the phase of the cycle. 

Commodity Cycles 

Now, let us understand commodity cycles. Industries such as steel, aluminium, copper, oil and gas, and chemicals can be heavily influenced by commodity cycles. When demand exceeds supply, commodity prices can rise and company profits may improve. 

However, higher profitability can eventually attract new capacity. As supply increases, prices may begin normalising and profitability can come under pressure. This cycle can repeat over time. 

One of the common mistakes in commodity investing is assuming that peak profits will continue permanently. Therefore, investors should not focus only on current earnings. They should also try to understand where the industry currently stands in the commodity cycle. 

Credit Cycles 

Credit availability is another important driver of economic activity. When interest rates are relatively low and credit is easily available, businesses may invest more, consumption can increase and overall economic activity can accelerate. 

When credit conditions tighten, borrowing becomes more expensive and growth can slow. Sectors such as real estate, banking, automobiles, infrastructure and capital goods can be particularly sensitive to credit conditions. This is why interest rates, lending activity and broader credit trends are important factors to monitor. 

Earnings Cycles 

Corporate earnings also move through cycles. During periods of strong demand, revenue and margins can improve, allowing profits to grow rapidly. 

Over time, however, competition may increase, demand may normalise and margins can begin moving back towards more normal levels. This is where investors can make a common mistake. They assume that the current rate of earnings growth will continue indefinitely. But earnings can also be cyclical. 

Peak-Cycle Profits 

At the peak of a cycle, earnings, margins and return ratios may all look extremely attractive. Management commentary may also be highly optimistic. However, this phase can sometimes be deceptive. Profitability may be benefiting from unusually favourable conditions that may not last indefinitely. 

If the cycle reverses, earnings can decline sharply even if the underlying business itself remains fundamentally healthy. This is why experienced investors often try to distinguish between peak earnings and sustainable earnings. 

Why a Low P/E Can Be Misleading 

Now, let us discuss an important valuation trap in cyclical stocks. In relatively stable businesses, a low P/E ratio may sometimes indicate an attractive valuation. But the same interpretation does not always work for cyclical businesses. 

Suppose a steel company normally earns ₹10 per share. During a commodity boom, earnings rise to ₹40 per share. If the share price is ₹400, the P/E ratio based on current earnings is: 

₹400 ÷ ₹40 = 10 times 

At first glance, the stock may appear inexpensive. But suppose the commodity cycle normalises and earnings return to ₹10 per share. At the same ₹400 share price, the valuation picture changes dramatically. The apparent low P/E was based on unusually high, peak-cycle earnings. 

This is why a low P/E in a cyclical company does not necessarily mean the stock is undervalued. It may simply reflect temporarily elevated earnings. Investors therefore often analyse normalised earnings rather than relying only on current earnings. 

The Cyclical Valuation Trap 

Cyclical stocks can sometimes behave in a way that appears counterintuitive. At the peak of the cycle: 

• Earnings can be at their highest.
• The P/E ratio may appear at its lowest. 

At the bottom of the cycle: 

• Earnings can be at their weakest.
• The P/E ratio may appear unusually high. 

Therefore, taking an investment decision based only on the P/E ratio can be risky in cyclical businesses. 

Investors should ask additional questions. 

• Are current earnings significantly above normal levels?
• Is the industry approaching the peak of its cycle or moving through a downturn?
• Are current margins sustainable?
• Is new supply or capacity entering the market?
• Does the current valuation adequately reflect cyclical risk? 

These questions can sometimes provide more useful insight than current profitability alone. 

Whenever you analyse a cyclical company, ask one important question: 

Is the current profitability sustainable, or is it simply the result of a favourable phase of the cycle? 

Understanding this distinction can help investors avoid several common mistakes while analysing cyclical companies. 

Conclusion 

In this video, we learnt that businesses, industries, earnings and markets can all move through cycles. We discussed the business cycle, market cycle, cyclical versus defensive sectors, commodity cycles, credit cycles, earnings cycles, peak-cycle profits and the low P/E valuation trap. The key takeaway is that investors should not evaluate a company only on the basis of current earnings or valuation multiples. They should also understand the cycle surrounding the business and whether current profitability is sustainable. 

In the next chapter, we will discuss Sector Rotation. 

See you in the next video. 

Disclaimer: Investments in securities markets are subject to market risks. Read all the related documents carefully before investing.