Why Markets Do Not Rise In A Straight Line

Summary

Prices are dominated by the fluctuations of the business cycle.

The business cycle causes prices to rise or decline.

Major turning points in the business cycle offer great risks and major investment opportunities.

Prices are influenced by growth in business activity. The patterns of growth – the business cycle - drive the main market cycles. And they affect stock prices, commodities, and bond yields. Everything else is noise from a money management viewpoint. 

                               Source: The Peter Dag Portfolio Strategy and Management

The turning points of a business cycle are crucial. In March 2020, for example, the business cycle transitioned from Phase 4 to Phase 1. This change favored transportation, industrials, commodity-sensitive sectors, and financials. It penalized a strategy emphasizing defensive sectors and bonds.

What are the causes of these turning points? Understanding what creates them may help to recognize the implications of the recent sharp rise in commodities, bond yields, and inflation.

Prices are driven by business decisions and the most difficult and far-reaching ones are those involved in assessing the level of production and capital investments. 

The business cycle declines, reflecting a slowdown of the economy (Phase 3), because business is penalized by excessive inventories as demand for their products weakens. Profitability, as a result, suffers at that time. The decision is made to scale down operations to re-establish profitability. Profitability will be finally reached when the causes that have affected it are brought under control. This is a particularly important point useful in timing new investment opportunities.

Inventory must be brought in line with demand. Purchases of raw materials must be cut because of lower production levels. Working hours and employment are also reduced. Borrowing needs to be lowered as well because of less ambitious production and investment activity.

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