This is a simplified version of how the business cycle progresses.  The detailed ins and outs aren’t necessarily that key for investors.  By far the most important thing  is to have a standard framework for trying to anticipate where new economic energy, hence earnings growth, will come from.

Preliminaries:

The most basic goal of US economic policy is maximum sustainable economic growth, meaning the highest number we can have without creating accelerating inflation.  The Federal Reserve is the primary agency charged with meeting this goal.  Its main tool is interest rate policy.  (Other countries have different basic goals.  For the EU or Japan, which suffered from hyper-inflation in the first half of the last century, the main thing is to have no inflation.  Economic growth comes second.)

The Fed seems to think that the maximum sustainable rate of growth for GDP in the US is about 2% per year now, and that inflation should be no more than about 2%.  This would mean that nominal growth should average about 4%.  These figures are lower than would have been the case twenty years ago, when the target numbers would have been 3% and 3%, meaning nominal growth of about 6%.

In this framework, the Fed has two roles.  It either provides interest rates that are low enough to stimulate growth when the economy is advancing at below its potential, or it raises rates to a level that slows growth when the economy is expanding rapidly enough to run the risk of accelerating inflation.

Starting out–the Road to Overheating

Let’s say that one day consumers decide, for one reason or another, to spend more in stores than they have been.  Stores realize that they don’t have enough sales help and that they’re starting to run out of merchandise.  So they hire more workers.  They call up factories and increase their orders.  If business is really good, they also ramp up their expansion plans, creating more demand for workers and materials in the construction industry.

Factories, in turn, have to hire more workers.  They, too, dust off their expansion plans, creating further ripples of expansion in the construction and machine tools industries.

At some point, the economy starts to run out of unemployed workers.  Companies that want to continue to expand can only do so by hiring workers away from other companies by offering higher salaries.  Wages, traditionally the main source of inflation in the US, start to accelerate.

Contractionary Phase–the Fed Raises Rates

The Fed’s role now changes from encouraging growth to protecting against inflation.  It raises interest rates.  The rise has two functions:  it has some economic effects by itself; it also serves a a signal that the Fed thinks the economy is growing too quickly and is going to do what it takes to slow things down.

Let’s look at what happens to a store.  Say that its policy is to have 10 weeks’ sales worth of merchandise on its shelves and that before the increase in customer buying it was selling 90 units a week.  So it had 900 units in stock, either in the store or somewhere else in its supply chain.  As customers raise their buying to 100 units a week, the store sees it only has 9 weeks worth of merchandise in stock.  But when it calls the factory, it most likely anticipates further increases in customer buying, so it raises its weekly order to 110 units and asks for an additional 200 units so that it will end up with 1100 units in stock.

After the Fed starts to raise rates, let’s say consumers cut their buying back to 80 units a week.  This would mean that the stores–partly because of their more aggressive attitude toward inventories, partly because of the customer pullback–now have 14 weeks of inventory in stock.  So the stores slow their expansion plans and cancel orders for  4 weeks worth of merchandise, as fast as they can.  After the stores phone their cancellations in, the factories are shocked to find themselves without any work for the next month.  They lay off workers and cancel their orders for new machine tools and buildings.  Because of this, the plant construction business may have no work for an even longer time.  They, too, reduce spending and lay off workers.

This process is called the inventory cycle because it revolves around the cyclical expansion and contraction of inventories of goods.  

In this example, a 20% change in consumer spending–which may result from a 10% decrease in income–creates inventories that are 40% more than stores want to carry, factory production that temporarily drops to zero and a capital goods industry that’s completely out of luck.  The numbers may be heroic but the distribution of pain is at least directionally correct.

Recovery and Expansion–the Fed Reverses Course

At some point, the economy slows below its trend rate of growth and the threat of inflation dissipates.  The Fed then switches roles in favor of promoting growth.  It begins to lower interest rates.  This move again has a dual character:  it stimulates growth and it signals that Fed policy has changed.  

In traditional financial theory, a lower interest rate makes some business capital spending projects viable that had made no economic sense at higher borrowing rates.  In one way of looking at recovery, these projects begin to be acted on.  If they haven’t already, layoffs stop.  Firms hire workers, who earn income and begin to spend more on goods.  This reinvigorates stores, which also hire more workers.  In other words, industry leads in recover, with the consumer following.  

In my experience, this is the path recovery takes in most places outside the US.  It isn’t the way it works here, though.  In the US inventory cycle, as soon as the Fed starts to lower rates consumers go back into the stores.  The consumer leads industry.  One explanation for this behavior is the “wealth effect,” the idea that the value of consumers’ houses or stock portfolios typically rise on the reversal of Fed policy and the accompanying feeling of greater prosperity leads to spending in advance of income growth.  The “wealth effect” explanation doesn’t have to be right.  It’s the behavior that counts.

Traditionally, a Four-Year Cycle…

This whole process used to take close to four years, with 2.5 years of expansion and 1.0-1.5 years of contraction in the economy and a similar pattern in the stock market, leading the economy by about six months.

…but Future Inventory Corrections May Have a Different Shape

This pattern may still hold true on the domestic side of emerging economies.  But in the US at least, we now have extensive supply chain software installed in the big companies in most industries.  The internet allows global dissemination of this information at low cost.  We have larger and more vertically integrated firms in many industries, so manufacturers can see far down the distribution chain.  As a result,  many of the uncertainties that compelled CEOs to react slowly to changing economic circumstances twenty or thirty years ago are now gone.  So the inventory cycle may look less like a sine wave and more like a sharp drop, long bounce along the bottom, sharp move up and gradual bounce upward.

The stock market has also changed, and can react to new economic information far more quickly than it used to be able to.  A huge market for derivatives is available now that was in its infancy thirty years ago.  Transaction volumes in the physical market are also very large multiples of what they were then.  And short-selling was less accepted as a mainstream institutional or individual investment strategy.    But in the old days, there were substantial barriers–apart from business considerations–that limited portfolio managers’ ability to quickly become more defensive or aggressive.

Looking back, I suppose that it shouldn’t be too surprising that the stock market cycle and the inventory cycle were closely related.  But we may find in the future that the traditional pattern of leads and lags between the economy and the stock market have been more a function of the instruments we have had at hand to express our economic conclusions than anything else, and so may no longer hold true.