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The inventory cycle predicted the markets in 2021 – that is now

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My latest article on the inventory cycle was published on May 18th, 2021. Back then, the economy was strong and the business cycle was on the upswing. Back then, the dynamics of the inventory cycle correctly indicated the following Snack:

Inventories to sales ratio indicated continued strength in manufacturing; Commodities and interest rates rise; Commodities and interest rates peaked as inventory-to-sales ratios began to rise; CAT and FCX to outperform the market.

The inventory cycle continued to support the above conclusions. However, important changes have now occurred. let me explain.

Economy

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The business cycle goes through four main phases. Each phase has a major impact on investment trends and is driven by how business decision makers respond to economic conditions.

In phase 1, the business experiences low inventories and stronger demand. Consumer optimism rises as post-inflation income improves thanks to falling inflation and falling interest rates. The business is responding to increased sales by raising production targets and building inventory.

Increasing production implies greater demand for raw materials and jobs, as well as increased borrowing to improve and increase capacity. The result is a floor in commodities and interest rates, and employment rises during this phase.

The positive loop of more income, more sales, more jobs, and more manufacturing brings the business cycle into phase 2. This is the time when the economy recovers above its historical average pace. Manufacturing is now expanding rapidly, putting upward pressure on commodities, wages, interest rates and headline inflation. Labor costs rise with inflation. Consumer optimism (Univ. of Michigan) is falling due to the drop in purchasing power caused by higher inflation.

Towards the end of Phase 2, these trends become a worrying development. The economy is overheating and the rise in inflation is causing real demand to slow down. The economy is now entering phase 3.

In phase 3, companies do not realize that consumers’ purchasing power is decreasing. The manufacturers continue to produce in order to keep unit costs low and to fully utilize the facilities.

However, there is a time in Phase 3 when sales are growing slower than inventory, causing costs to increase more than expected, negatively impacting earnings. The company then decides to throttle production to protect revenue. The result is a drop in commodity orders, a drop in borrowing and layoffs. However, inflation continues to rise, further reducing consumer purchasing power.

The economic cycle is now in phase 4, the most important phase for investors because of the risk of large losses in share prices. This is the time when bear markets are fully rampant and all the excesses that arose in the previous stages are eliminated.

The business cycle is in phase 4. It lasts as long as:

  1. Inventory growth declines and aligns with sales growth. Inventory growth will need to slow down to about 3% post-inflation according to recent history.
  2. Commodities and interest rates fall as companies reduce commodity purchases and borrowing in an attempt to curb inventory growth.
  3. Inflation and labor costs are finally coming down. This is an important development, accompanied by increasing consumer optimism due to increased purchasing power and improving revenues.

The business cycle will enter phase 1 after the above developments.

I/S ratio

BLS

The chart above shows the ratio of inventory to sales in May 2022 (published on July 15, 2022 by the Bureau of Labor Statistics). The ratio is increasing, which is due to inventories growing faster than sales. For example, as of this writing, wholesaler inventories are up +16.2% yoy after inflation. Meanwhile, post-inflation retail sales are down -0.6% yoy and personal income is down -3.3% yoy post-inflation.

inventory, sales, income

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Inventories are being aggressively reduced as they weigh heavily on earnings. Production is reduced to the point where post-inflation inventory growth is in the 2% to 4% range.

raw materials

The Peter Dag portfolio strategy and management

Meanwhile, commodities and long-term interest rates will continue to fall to reflect slower growth in business activity caused by falling production and inventories (see chart above).

CAT, FCX

The Peter Dag portfolio strategy and management

As suggested in the article referenced above, Caterpillar (CAT) and Freeport-McMoRan (FCX) are likely to outperform the market in a rising economic cycle, as reflected in the rising CAT/SPY and FCX/SPY ratios (see panels above).

Now that the inventory correction is forcing the economic cycle into a slowdown (see lower panel in chart above), CAT and FCX are likely to underperform the market – the CAT/SPY and FCX/SPY ratio is declining. This underperformance will continue as long as the business cycle turns down.

key to take away

  • The business cycle is in phase 4. Inventory growth remains excessive and needs to be scaled back to low single digit growth after inflation.
  • Accompanying the inventory slowdown are lower stock prices (SPY), lower commodities, lower yields, lower growth in manufacturing, employment and general business activity.
  • The process will continue until inflation falls in a convincing manner, which is enough to boost consumer optimism. Labor costs will also slow, improving earnings prospects.
  • This is the time when the stock market (SPY) bottoms and stocks like Caterpillar and Freeport-McMoRan start to outperform the market (SPY) again.

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