Let's assume again that inventories are low and that business decides to increase their level (Fig. 3-2). Business must then increase production, hire more people, income and sales increase, and the inventory-to-sales ratio declines. Inventory must be replenished as sales keep growing faster than inventory at the beginning of the expansion of the business cycle.

As production increases, capacity utilization also increases. Capacity utilization provides information on productive capacity in the country. Capacity utilization represents the percentage of the total capacity that is currently being used for production purposes. It is computed by dividing the production output by a percentage of total capacity. There is a point when business recognizes that capacity needs to be expanded in order to meet ever increasing sales and to improve productivity. The increase in sales and investment in new capacity results in higher orders for durable goods and consumer goods. This reinforces the need to increase production, not only to meet sales, but also to satisfy the increased orders. The process continues and feeds on itself and the economy expands strongly.

Why does the economy eventually slow down? For the same reason we mentioned in the previous section -- employment is a scarce resource. But capacity is also a scarce resource. At the beginning of the cycle, when capacity utilization is low and there is a high unemployment rate, there are a lot of people to hire and a lot of capacity to utilize. Strong growth can be accommodated until scarce resources (labor and capacity) are more fully utilized.

However, when the employment rate is low and capacity utilization is high, growth cannot be supported as it was at the beginning of the business cycle. Growth has to slow down. A decline in growth in sales will also be reflected in a slowdown in investments, in orders, and therefore in production.

The inventory-to-sales ratio is a regulating mechanism guiding business to increase or decrease production and capacity expansion. As the economy slows down, borrowing for investments and borrowing to finance purchases by consumers will also slow down. The upswing in production and the investment cycle will be underway again when inventories have declined enough to justify a resumption of output. It must be noted that the strengthening and weakening in borrowing activity is connected to the inventory build-up and capacity expansion and is one of the major forces acting on short-term and long-term interest rates.

Let’s look again at the 1993-1995 business cycle. The sharp decline in short-term interest rates that took place from 1991 through 1993 caused consumers to buy more aggressively and sales growth and employment growth to increase rapidly; as the inventory-to-sales ratio declined in 1994 because of the strong economy, manufacturing felt compelled to increase production.

he outcome was that capacity utilization started to increase, reflecting the increased production. The sharp growth of the economy in 1994 created disruptions, such as rising inflation, rising commodity prices, rising interest rates, and forced consumers to be more cautious as far as their purchase plans were concerned.

The outcome was a sales slowdown, the inventory-to-sales ratio rose, the manufacturing sector realized what was happening and slowed down production to bring inventories under control, and capacity utilization began to decrease again as less and less capacity was utilized to meet slower growth in sales.

The outcome of this action was to bring the inventory-to-sales ratio under control to bring inventories more in line with sales growth. Of course, this action created a slowdown in 1995.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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