My last article on the inventory cycle was published On 5/18/2021. At that time, the economy was going strong, and the business cycle was in a boom. At that time, the inventory cycle dynamics correctly indicated the following Takeaway:
The inventory-to-sales ratio was indicative of continued strength in manufacturing; Commodities and interest rates on the rise; Commodities and interest rates peak when the inventory-to-sales ratio begins 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.
The business cycle passes through four main phases. Each stage has significant implications for investment trends and is driven by how business decision makers react to economic conditions.
In the first stage, the business is experiencing declining inventories and increased demand. Consumer optimism increases as incomes improve after inflation thanks to lower inflation and interest rates. Businesses respond to increased sales by raising production targets and building inventories.
Increased production means greater demand for raw materials and labour, and more borrowing to improve and increase capacity. The result is lower commodity and interest prices, and higher employment at this point.
The positive cycle of more income, more sales, more employment, and more production takes the business cycle to the second stage. This is the time when the economy is strengthening above its average historical pace. Production is now rising rapidly and putting upward pressures on commodities, wages, interest rates and general inflation. Labor costs increase with inflation. Consumer optimism (University of Michigan) declines due to lower purchasing power caused by higher inflation.
At the end of the second phase, these trends became a worrying development. The economy is overheating and an increase in inflation is slowing down real demand. The economy is now entering the third stage.
In stage 3, businesses are not aware that the purchasing power of consumers is decreasing. Manufacturers continue production to keep unit costs low and plants to operate at full capacity.
However, there comes a time in stage 3, when sales grow at a slower pace than inventories causing costs to rise more than expected, negatively affecting profits. The company then decides to cut production to protect profits. The result is a decrease in orders for raw materials, a decrease in borrowing, and layoffs. However, inflation continues to rise, reducing the purchasing power of consumers.
The business cycle is now in the fourth stage, which is the most important stage for investors due to the risks of a significant decline in stock prices. This is the time when the bear markets are widespread and all the excesses created in the previous stages are removed.
The duty cycle is in stage 4. It will continue as long as:
- Inventory growth declines and is in line with sales growth. Inventory growth should drop to around 3% after inflation according to recent history.
- Commodity and interest prices fall as the business reduces purchase of raw materials and borrowing due to trying to reduce inventory growth.
- Inflation and labor costs are finally coming down. This is a significant development accompanied by increased consumer optimism due to increased purchasing power and improved profits.
The first stage business cycle will move after the above developments.
The chart above shows the ratio of inventory to sales 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 example, wholesaler inventories are up at a +16.2% year-over-year after inflation. Meanwhile, post-inflation retail sales fell -0.6% y/y, and personal income fell -3.3% y/y after inflation.
Inventories will be reduced drastically as it affects profits greatly. Production will be reduced enough to achieve inventory growth in the 2%-4% range after inflation.
Meanwhile, commodities and long-term interest rates will continue to decline to reflect lower growth in business activity caused by lower production and inventories (see chart above).
As suggested in the above article, caterpillar (cat) and Freeport-McMoRan (FCX) The market is likely to outperform the bull business cycle as evidenced by the higher CAT/SPY and FCX/SPY ratio (see panels above).
However, now that the stock correction is forcing the business cycle lower (see bottom panel in the above chart), CAT and FCX are likely to underperform the market – CAT/SPY and FCX/SPY are down. This poor performance will continue as long as the business cycle is trending downward.
- Stage 4 business cycle. Inventory growth remains excessive, and should be reduced to low single-digit growth after inflation.
- A slowdown in inventory will be accompanied by a fall in stock prices (spy), lower commodities, lower returns, lower growth in production, employment, and overall business activity.
- The process will continue until inflation begins to decline in a convincing manner, enough to improve consumer optimism. Labor costs will also slow, improving earnings expectations.
- This is when the stock market bottoms (SPY) and stocks like Caterpillar and Freeport-McMoRan start outperforming the market (SPY) again.