The Inventory Cycle - A Boring But Important Market Setter

Summary

Government and Fed stimulus create volatility.

But business must navigate through it and replenish the shelves.

Inventory management moves the markets.

What I wrote on 11/24/2020 is still valid today. On November 24, 2020 I published the article The Inventory Cycle - Boring But Important Market Setter. The main idea was to review a simple indicator and its impact on the business cycle, commodities (JJC, XLB, and XME), and commodity sensitive stocks (FCX and CAT).

What is the “boring indicator” saying now?

Source: The Peter Dag Portfolio Strategy and Management

Business managers must filter all the news coming from different sources such as pandemics, cartels, supply chain difficulties, foreign or domestic supplier availability, trends in commodities and interest rates, changes in value of the dollar, and the Fed. They must make a crucial decision: how much to produce to replenish the inventories at levels needed to meet the demand for their goods.

The business cycle transitions through four phases as management changes its inventory policies. In Phase 1 and Phase 2 business decides to build inventories to meet growing demand. This decision results in increases in the purchase of raw materials, hiring more people, increase in borrowing to finance operations and improve and expand capacity. 

This is the time the business cycle grows through Phase 1 and Phase 2. This is also the time commodities, copper, crude oil, lumber, agriculturals, interest rates, and inflation rise. The increase in these prices is a testimonial the economy is strengthening.

The problem arises toward the end of Phase 3. The continued rise in commodities, crude oil, and inflation eventually reduces consumers’ purchasing power in a meaningful way. The response is a slowdown in spending. 

In Phase 3 managers begin to experience rising inventories compared to sales with a direct impact on their financial performance. The need to reduce inventories involves cuts in the purchase of raw materials, reduction in the workforce, and declines in borrowing. This process will continue until inventories are in line with demand. The inventory to sales ratio keeps rising during these times. During Phase 3 and Phase 4, because of the action of business, commodities decline, wages slow down, and interest rates decline. 

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