Question

List and discuss some of the limitations of the cyclical/non-cyclical descriptive approach to classifying companies (120 words minimum)

List and discuss some of the limitations of applying business-cycle analysis to global industry analysis. (120 words minimum)

Answer 1

The terms cyclical and non-cyclical refer to how closely correlated a company's share price is to the fluctuations of the economy.

Cyclical Companies :::

Cyclical companies follow the trends in the overall economy, which makes their stock prices very volatile. When the economy grows, prices for cyclical stocks go up. When the economy turns down, their stock prices will drop. They follow all the cycles of the economy from expansion, peak, and recession all the way to recovery.

Cyclical stocks represent companies that make or sell discretionary items and services that are in demand when the economy is doing well. They include restaurants, hotel chains, airlines, furniture, high-end clothing retailers, and automobile manufacturers. These are also the goods and services that people cut first when times are tough.

When people delay or stop buying anything dispensable, the revenues of the companies that produce and sell them fall. This, in turn, puts pressure on their stock prices, which start to drop. In the event of a long downturn, some of these companies may even go out of business.

Non-Cyclical Companies :::

Non-cyclical stocks repeatedly outperform the market when economic growth slows.

Non-cyclical securities are generally profitable regardless of economic trends because they produce or distribute goods and services we always need, including things like food, power, water, and gas.

The stocks of companies that produce these goods and services are also called defensive stocks because they can defend investors against the effects of economic downturn. They are great places in which to invest when the economic outlook is sour.

For example, non-durable household goods like toothpaste, soap, shampoo, and dish detergent may not seem like essentials, but they really can't be sacrificed. Most people don't feel they can wait until next year to lather up with soap in the shower.

A utility company is another example of a non-cyclical. People need power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically.

This is a key fact about non-cyclical stocks. They provide safety, but they are not going to skyrocket in price when the economy grows.

Investing in non-cyclical stocks is a good way to avoid losses when highly cyclical companies are suffering.

Answer to part B---

One limitation of the cyclical/non-cyclical classification is that business-cycle sensitivity is a continuous spectrum rather than an “either/or” issue, so placement of companies into one of the two major groups is somewhat arbitrary. Another limitation is that different countries and regions of the world frequently progress through the various stages of the business cycle at different times.

Groupings by statistical similarities also tend to be somewhat arbitrary, and the composition of groups may vary significantly across time periods and world regions. Also, there is no guarantee that past correlation values will continue in the future. Finally, all statistical methods are at risk of falsely finding relationships that don’t actually exist or of excluding a relationship that actually is significant.