Cyclical stocks are stocks that witness a sharp change in revenue and earnings with changes in business cycles.
When market sentiments are bullish and the economy is performing at potential GDP, it makes sense to remain invested in cyclical stocks. On the other hand, when market sentiments are bearish and there is a recessionary gap, cyclical stocks underperform.
With expansionary monetary policies, the probability of recession in the United States has declined. However, uncertainties sustain with a second wave of coronavirus infections in Europe. A similar scenario in the U.S. would delay growth acceleration.
Further, markets still trading near all-time highs and investors need to remain cautious. In particular, the portfolio weight of cyclical stocks can be reduced if a bear market settles-in. Since cyclical stocks have a high beta, a downturn can have a significant negative impact on the portfolio.
This column will discuss four cyclical stocks that should be avoided in a bear market scenario. Let’s look at the following stocks.
- Freeport-McMoRan (NYSE:FCX)
- Vale (NYSE:VALE)
- American Airlines Group (NASDAQ:AAL)
- Royal Caribbean Group (NYSE:RCL)
Cyclical Stocks: Freeport-McMoRan (FCX)
FCX stock is possibly among the best names among commodity cyclical stocks. The stock has been an outperformer, having skyrocketed by 174% in the last six months. The big rally is the first reason to remain cautious at current levels. Further, FCX stock has a beta of 2.36. In a bear market scenario, the stock can decline sharply.
Of course, investors can keep FCX stock in the investment radar. I like the fact that the company has focused on deleveraging. As of June 2020, the company reported net debt of $8.4 billion. By the end of next year, the company expects to reduce net debt to $5.3 billion.
In addition, the company is expecting to increase copper and gold sales in the next few years. If copper and gold price does trend higher, it will translate into robust cash flows.
On the flip side, the company’s performance is entirely dependent on economic activity. According to The Brookings Institution, U-shaped recovery is most likely after the coronavirus pandemic. Therefore, a bear market cannot be ruled out. The company’s leverage and growth target are unlikely to be achieved in that scenario.
Overall, FCX stock is a quality name in the industrial commodities industry. However, investors need to remain cautious with this high beta stock after a big rally. Additionally, profit booking should be considered, and fresh exposure avoided in a bear-market scenario.
Vale stock has already been an underperformer having declined by 4.5% in the last one year. The stock has still not recovered from the financial pain following the dam disaster in January 2019. I further believe that this industrial commodity name should be avoided in a bear market scenario.
In a recent news, Brazil prosecutors have opined that the company’s mining dams are still a risk. Further, Vale needs to do more to prevent another disaster. This would potentially imply more cash burn or the risk of mining closures. Besides the bear market factor, this is a major reason to remain cautious on VALE stock.
Iron ore futures have declined in the recent past. China’s crude steel production hit another record. However, as Maike Futures analyst Ban Peng points out that “consumption levels we are seeing in the first half of the month haven’t met market expectations.” It might therefore be too early to believe that the recovery is sustained.
In terms of positives, Vale reported net debt of $4.7 billion in the second quarter of 2020. In the second quarter of 2019, the company’s net debt was $9.7 billion. Lower debt levels will help the company navigate through challenging times.
American Airlines Group (AAL)
The airline industry has been among the worst impacted by the novel coronavirus pandemic. Its therefore not surprising that AAL stock has declined by 58% in the current year. I further believe that AAL stock, which has a beta of 1.75, should be avoided in a bear market scenario.
The International Air Transport Association believes that global passenger traffic will not return to pre-Covid-19 levels until 2024. Moody’s also sees a recovery by the end of 2023 in the best-case scenario.
Even if the broad markets do not enter a bearish territory, the airlines industry is in an extended bear market. Therefore, AAL stock might remain depressed as cash burn sustains in the coming quarters.
In terms of positives, American Airlines ended the second quarter with a total liquidity buffer of $10.2 billion. This will help the airline navigate the coming quarters.
However, the concern is that the company already has significant debt and a stockholders’ deficit. Recovery in terms of financials will take years. This makes the stock unattractive even if business growth gains traction in the coming year.
Royal Caribbean Group (RCL)
Among travel and tourism stocks, RCL stock is another name that should be avoided. Post the novel coronavirus triggered crash, RCL stock has surged by 74% in the last six months. For a stock with a beta of 2.68, it makes sense to remain in the sidelines if markets turn bearish in-sync with sluggish economic activity.
Besides the bear market factor and its impact on cyclical stocks, it’s important to note that Europe is already experiencing a second wave of coronavirus infections. This is bad news for Royal Caribbean as commencement of cruises might further be delayed.
From a liquidity perspective, the company reported cash and equivalents of $4.1 billion as of June 2020. In addition, the company has $11.3 billion of committed credit facilities that are available to fund ship deliveries. Therefore, survival is not a concern.
However, I believe that cash burn is likely to sustain for an extended period. This might depress the stock after a big rally in the last six months.
Overall, it’s too early to believe that cruising demand will return to normal in the coming year. Consumers might prefer to delay luxury spending if economic uncertainties persist.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.