The inventory cycle predicted markets in 2021 – this is now

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My last article on the inventory cycle was published on 5/18/2021. At the time, the economy was strong and the business cycle was picking up. At that time, the dynamics of the inventory cycle correctly indicated the following take away:

The inventory / sales ratio indicated continued strength in the manufacturing sector; commodities and rising interest rates; commodities and interest rates will peak when the inventory / sales ratio has started to rise; CAT and FCX to outperform the market.

The inventory cycle continued to support the above conclusions. Now, however, important changes have taken place. Let me explain.

Business cycle

Peter Dag’s strategy and portfolio management

The business cycle goes through four main phases. Each phase has important implications for investment trends and is driven by how business decision makers react to economic conditions.

In phase 1 the business experiences low inventory and stronger demand. Consumers’ optimism increases as inflation-adjusted income improves thanks to lower inflation and interest rates. The company responds to increased sales by increasing production targets and building inventory.

Increased production implies increased demand for raw materials and employment and increased loans to improve and increase capacity. The result is the low of commodities and interest rates and employment increases at this stage.

The positive cycle of more revenue, more sales, more employment, more production brings the business cycle into Phase 2. This is the time when the economy strengthens above its historical average pace. Production is now increasing rapidly and exerts upward pressure on commodities, wages, interest rates and headline inflation. Labor costs rise with inflation. Consumer optimism (Univ. Of Michigan) wanes due to the drop in purchasing power caused by rising inflation.

Towards the end of Phase 2 these trends become a worrying development. The economy is overheating and rising inflation causes real demand to slow down. The economy now enters Phase 3.

In Phase 3, the business does not recognize that the purchasing power of consumers is decreasing. Producers continue to produce to contain unit costs and the plants are running at full capacity.

There is a time in Phase 3, however, when sales grow at a slower pace than inventory, causing costs to rise more than expected, negatively impacting earnings. The company then decides to cut production to protect earnings. The result is a drop in commodity orders, a drop in loans and layoffs. Inflation, however, continues to rise, further reducing consumers’ purchasing power.

The business cycle is now in Phase 4, the most important phase for investors due to the risk of sharp falls in share prices. This is the time when large-scale bear markets are rampant and all excesses created in the previous stages are removed.

The business cycle is in Phase 4. It will last as long as:

  1. Inventory growth decreases and aligns with sales growth. According to recent history, inventory growth will have to drop to around 3% after inflation.
  2. Commodities and interest rates decline as firms reduce commodity purchases and borrowing due to an attempt to reduce inventory growth.
  3. Inflation and labor costs are finally falling. This is an important development accompanied by growing consumer optimism due to increased purchasing power and improved profits.

The business cycle will move to Phase 1 following the above developments.

I / S ratio

BLS

The chart above shows the inventory / sales ratio as of May 2022 (published July 15, 2022 by the Bureau of Labor Statistics). The ratio is increasing, reflecting inventory growing faster than sales. At the time of writing, for example, wholesalers’ inventories are rising at a rate of + 16.2% yoy after inflation. Retail sales after inflation, meanwhile, fell -0.6% yoy and personal income fell -3.3% yoy after inflation.

Inventory, sales, income

Peter Dag’s strategy and portfolio management

Inventories will be cut aggressively because they impact earnings in a major way. Production will be reduced enough to bring inventory growth in the range of 2% -4% after inflation.

Goods

Peter Dag’s strategy and portfolio management

Meanwhile, commodities and long-term interest rates will continue to decline to reflect the lower growth in entrepreneurial activity caused by declining production and inventories (see chart above).

CAT, FCX

Peter Dag’s strategy and portfolio management

As suggested in the aforementioned article, Caterpillar (CAT) and Freeport-McMoRan (FCX) are likely to outperform the market in a rising business cycle, as demonstrated by the rising CAT / SPY and FCX / SPY ratio (see boxes above) .

However, now that the inventory correction is forcing the business cycle to decline (see lower box in the chart above), CAT and FCX are likely to underperform the market – the CAT / SPY and FCX / SPY ratio is down. This underperformance will continue until the business cycle subsides.

Key takeaway

  • The business cycle is in phase 4. Inventory growth remains excessive and must be reduced to low single-digit growth after inflation.
  • The slowdown in inventories will be accompanied by lower stock prices (SPYs), lower commodities, lower yields, lower production growth, employment and trading activity in general.
  • The process will continue until inflation begins to decline convincingly, enough to improve consumer optimism. Labor costs will also slow down, improving earnings prospects.
  • This is where stock market lows (SPY) and stocks like Caterpillar and Freeport-McMoRan begin to outperform the market (SPY) again.

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