Why Markets Do Not Rise On A Straight Line.

Source: The Peter Dag Portfolio Strategy and ManagementThe 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.

These decisions are made all at the same time by businesspeople all around the country. The outcome will be lower commodity prices, lower wages, lower interest rates, and lower inflation. These declines will last until they are reflected in improved profitability. This is the time managers will stop cutting production with all its implications on prices and inflation.

From a demand viewpoint, consumers are now in better shape with purchasing power increased due to the decline in inflation and interest rates. These conditions – improved profitability and increased purchasing power – cause the transition of the business cycle from Phase 4 to Phase 1.

The increased demand will force businesses to hire workers, to pay higher wages, buy raw materials, and increase borrowing. This process feeds on itself and the positive feedback will cause business to further increase production and to grow.

The strength of production efforts accompanied by rising demand will eventually cause raw material prices, energy prices, bond yields, and inflation to rise. This is the signal the economy is running above capacity and is now well into Phase 2.

Eventually, these price increases will have a negative impact on consumer behavior. Purchasing power declined as rising inflation and interest rates dampen consumer demand.

The business cycle has now reached the end of Phase 2. Business does not recognize demand is waning and keeps producing goods to replenish inventories. As demand keeps slowing down, however, rising inventories have a negative impact on earnings.

The decision is made to cut production and the business cycle moves to Phase 3.

The turning points in the business cycle signal risk and opportunities in the stock market and in the overall portfolio management. They also suggest two opposite investment strategies whether the busines cycle moves from Phase 2 to Phase 3 or from Phase 1 to Phase 2.

The reason I suggested in my article “The Bond Market Is Tightening. The Fed Is In A Box. The Economy Will Pay.” is because the current rising trend in commodities, interest rates, and inflation suggests we are in the middle of Phase 2. The only way to “ease” and bring bond yields down is an economic slowdown – the business cycle must enter Phase 3.

The following chart supplies the justification for the last point.

Read More:Why Markets Do Not Rise On A Straight Line.

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