The Inventory Cycle Predicted The Markets In 2021 - This Is Now

Aug. 06, 2022 1:03 AM ETFCX, SPY, CAT4 Comments7 Likes
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George Dagnino
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Summary

  • Business makes inventory decisions as economic conditions change.
  • Business must adjust production levels to maintain inventory levels, consistent with sales growth.
  • These inventory decisions have a major impact on the economy, financial markets, and stock selection.

Logistic worker staff colleague in safety suit holding computer laptop working in a warehouse store

Danai Jetawattana/iStock via Getty Images

My latest article on the inventory cycle was published on 5/18/2021. At that time, the economy was strong, and the business cycle was on an upswing. At that time, the dynamics of the inventory cycle pointed correctly to the following takeaways:

The inventory to sales ratio was pointing to continued strength in manufacturing; commodities and interest rates to rise; commodities and interest rates to peak when the inventory to sales ratio started to rise; CAT and FCX to outperform the market.

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

Business cycle

The Peter Dag Portfolio Strategy and Management

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

In Phase 1 business experiences low inventories and stronger demand. Consumers' optimism increases as income after inflation improves thanks to declining inflation and interest rates. Business responds to increased sales by raising production targets and building up inventories.

Increasing production implies more demand for raw materials and employment, and increased borrowing to improve and increase capacity. The outcome is commodities and interest rates bottom, and employment increases in this phase.

The positive loop of more income, more sales, more employment, more production takes the business cycle into Phase 2. This is the time the economy strengthens above its historical average pace. Production is now rising rapidly and places upward pressure on commodities, wages, interest rates, and overall inflation. Labor costs increase with inflation. Consumers' optimism (Univ. of Michigan) declines because of the decline in purchasing power caused by higher inflation.

Toward the end of Phase 2 these trends become a concerning development. The economy is overheating and the increase in inflation causes a slowdown in real demand. The economy now enters Phase 3.

In Phase 3 business does not recognize consumers' purchasing power is decreasing. Manufacturers keep producing to keep unit costs down and plants operating at full capacity.

There is a time in Phase 3, however, when sales grow at a pace slower than inventories causing costs to rise more than anticipated, negatively impacting earnings. Business decides then to cut production to protect earnings. The outcome is declines in orders for raw materials, declines in borrowing, and layoffs. Inflation, however, keeps rising, further reducing consumers' purchasing power.

The business cycle is now in Phase 4, the most important phase for investors because of the risk of large drawdowns in equity prices. This is the time full-scale bear markets are rampant and all the excesses created in the previous phases are removed.

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

  1. Inventory growth declines and is brought in line with that of sales. Inventory growth will have to decline to about 3% after inflation according to recent history.
  2. Commodities and interest rates decline as business reduces the purchase of raw materials and borrowing because of the attempt to cut inventory growth.
  3. Inflation and labor costs finally decline. This is a major development accompanied by rising consumer optimism due to the increase in purchasing power and improvement in earnings.

The business cycle will transition in Phase 1 following the above developments.

I/S ratio

BLS

The above graph shows the inventory-to-sales ratio as of May 2022 (published July 15, 2022, by the Bureau of Labor Statistics). The ratio is rising, reflecting inventories growing more rapidly than sales. As of this writing, for instance, wholesalers' inventories are soaring at a +16.2% y/y pace after inflation. Retail sales after inflation, meanwhile, have declined -0.6% y/y, and personal income is down -3.3% y/y after inflation.

Inventory, sales, income

The Peter Dag Portfolio Strategy and Management

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

Commodities

The Peter Dag Portfolio Strategy and Management

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

CAT, FCX

The Peter Dag Portfolio Strategy and Management

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

However, now that the inventory correction is forcing the business cycle to decline (see lower panel on the above chart), CAT and FCX are likely to underperform the market - the ratio CAT/SPY and FCX/SPY is declining. This underperformance will continue as long as the business cycle heads lower.

Key takeaway

  • The business cycle is in Phase 4. Inventory growth remains excessive, and it must be scaled down to low single-digit growth after inflation.
  • The inventory slowdown will be accompanied by lower stock prices (SPY), lower commodities, lower yields, lower growth of production, employment, and overall business activity.
  • The process will continue until inflation starts declining in a convincing way, enough to improve consumers' optimism. Labor costs will slow down as well, improving the outlook of earnings.
  • This is the time when the stock market (SPY) bottoms and stocks like Caterpillar and Freeport-McMoRan start outperforming the market (SPY) again.

This article was written by

George Dagnino profile picture
834 Followers
George Dagnino. Economist -- Investment strategist -- Portfolio manager – Author - Editor of THE PETERDAG PORTFOLIO STRATEGY AND MANAGEMENT on www.peterdag.com. Complimentary subscription is available.Nationally recognized speaker on business cycles George Dagnino, Ph.D. is the former Chief Economist and Risk Manager for a major corporation where he managed $4 billion of interest rates and currency hedge portfolios. The Economist Intelligence Unit (London) wrote an article about his unique and successful approach to managing risk (interest rates and currencies) using derivatives. Dr. Dagnino is 1989 market timer of the year (Source: Timer Digest) He is also the author of three books: *** "PROFITING IN BULL OR BEAR MARKETS," published by McGraw-Hill, available in Asia in several editions from McGraw-Hill Education. *** EASY WAYS TO BEAT THE MARKET WITH ETFs *** INVESTING WISELY, IT EASIER THAN YOU THINK He taught MBA courses business and portfolio management. He has a Ph.D. from Case Western Reserve, Cleveland, Ohio. He is also an internationally recognized speaker and lecturer to many AAII investment groups, hedge funds, Europe, and China.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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