Let's consider first the indicators concerning the behavior of consumers, and see how they act during a typical business cycle (Fig. 3-1). Let's assume that inventories are low. As a result, business decides to increase inventories because they expect sales to improve. The first step is an increase in the average workweek and in overtime because corporations want to make sure their recovery is a lasting one before increasing employment. Unemployment claims will likely decline and because of improved conditions, consumer sentiment, which was low due to poor economic growth, starts rising.

The increased workweek and overtime result in higher production levels, which are accompanied by high employment and higher income. As consumers increase their take-home money, they spend more and sales accelerate. The strength in sales will produce a decline in the inventory-to-sales ratio as sales grow faster than inventories at the beginning of the recovery.

Of course, the increase in consumer confidence further reinforces the strength in sales. As the inventory-to-sales ratio declines, the business sector decides to further increase the workweek, overtime, and production. This process will eventually result in higher employment, further increasing income and sales. Consumer confidence remains strong as the inventory-to-sales ratio continues to decline and the need arises to replenish inventories. This cycle repeats itself and the economy improves, growing faster and faster.

The question is why the economy eventually begins to slow down. The main reason is employment becomes scarcer. At the beginning, business rises rapidly after a period of slowdown because there are many people ready to be hired. As the labor force is increasingly used, there are fewer people to hire; therefore, the growth in employment has to slow down.

The slowdown in employment results in a slowdown in both income and sales. Slower growth in sales makes the inventory-to-sales ratio rise, which means business has to adjust inventories down. This downward adjustment in inventories results in a shorter workweek, overtime, and slower growth in production.

Consumer confidence declines because there is a slowdown in overall employment and in income. As a result, sales growth continues to decline as the unemployment rate slowly increases. Even though the inventory-to-sales ratio continues to rise, the adjustment process goes on as business continues to cut inventory costs. The economy reflecting this downshifting is now growing very slowly. However, eventually inventories are cut so low that business decides to replenish them, because they know that they will have to meet a certain level of sales.

Replenishing inventories triggers the business cycle again. This readjustment of replenishing inventories causes overtime to rise at first, then employment, which translates into higher income. The upswing in the business cycle is underway again. This is a very simple model, but it helps to explain why growth at the beginning of the slowdown is fast and then is bound to slow down because economic resources are scarce. The emphasis has been placed on the inventory adjustment mechanism. In later chapters, the role of the Fed, inflation, and interest rates will be included to make the process more complete.

What happened to the business cycle from 1992 to 1995 offers a good example of what happens in the business and financial markets, even in the absence of a recession. We will see how slight changes in economic growth can drive prices of assets in major ways.

The basic feature of what occurred from 1992 to 1995 is that the financial cycle that began in 1992 was caused by the recession of 1990 and the early part of 1991. What is interesting is that this shows how the main features of a cycle are influenced by some characteristics of the previous cycle. In 1991 a new financial cycle began. We will discuss in detail later what a financial cycle is. The increase in the growth of the money supply was the important sign that a new financial cycle was under way. The role of the Fed during this phase of the financial cycle will be discussed in detail in Chapter 6. That was also the time when the great real estate crisis and savings and loan crisis were underway in the U. S. and created major disruptions.

Because of these crises, the Federal Reserve fulfilled its function of lender of last resort by providing liquidity in the system, in order to isolate the crises and keep them within the real estate sector and savings and loan sector. But the outcome was that this aggressive growth in the money supply created ripples throughout the economy. In 1994 the economy started growing very rapidly because of the aggressive easing of the Federal Reserve. The outcome was an acceleration in employment, income, and sales.

Because of the strong sales and a cautious manufacturing sector, the inventory-to-sales ratio declined sharply, as sales were growing faster than inventories. Unemployment claims were also declining in response to faster growth in employment. However, the strong growth of 1994, created a series of events that caused consumers to become more cautious. The outcome has been a slowdown in sales and income and employment.

In the meantime, manufacturing experienced an increase in the inventory-to-sales ratio in 1995 and slowed down production in employment. At that point, the business cycle experienced a slowdown in 1995, which was necessary to create the conditions for stronger growth in 1996 and beyond.

(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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