The 1974-75 recession was exacerbated by de-stocking

This is illustrated in more detail in Figure 20. The blue data is the 1973-1977 cycle (the centre of the chart is July 1975) and the black data is the current cycle, i.e. August 2007 up to November 2011. If we look first at the blue data, note how the cycle develops:

Industrial production starts to contract. As the recession gets underway, industrial production starts to fall as economic activity reduces.

Industry becomes over-stocked. In a sharp downturn, orders fall much faster than inventories and the columns in Figure 20 (i.e. new orders less inventory) go negative. This means that supply channels are becoming overstocked.

IP falls even faster as companies de-stock. The increasing overstock leads companies to reduce production rates to well below demand with the result that IP shrinks at a faster and faster rate.

The over-stock turns into an under-stock. The very rapid IP contraction means that the overstock very quickly becomes an understock (i.e. the new orders less inventory columns turn positive). Note how in Figure 20, the trough in IP contraction occurs almost simultaneously with the peak in understock.

IP then rebounds very sharply as companies normalise production rates. At the first sign of demand stabilising, companies realise that they have too little inventory and start to bring production back in line with demand. There are two important points to note here. First, this is not re-stocking, this is just the end of de-stocking. Second, normalising production rates shows up as growth because factories are producing at a faster rate than when they were de-stocking.

The recovery then kicks in (hopefully…). The final phase of the inventory cycle is when economic growth returns and the usual GDP/IP relationship kicks in.

The 2008-2010 inventory cycle was a re-run of 1973-1977

The black data in Figure 20, which shows the data from August 2007 to now, was amazingly similar to the blue 1970s data in the period 2008-2010. There was a major destock

in 2009 followed by a bounce in IP as the de-stock came to an end. We should stress that such extreme inventory cycles are rare in the capital goods universe but are actually quite common in sectors where either demand is more volatile and/or supply chains are very long. Consumer electronics is a classic example of this.

The inventory cycle is no longer supportive

Unfortunately the relationship between the 1973-1977 inventory cycle and the current cycle is breaking down with IP slowing and orders broadly similar to inventories. This suggests that future growth will depend on GDP, not the inventory cycle

Eoin Treacy's view Prior to July 2011 there was a great deal of commonality between capital goods manufacturers and consumer led sectors. Both were perceived to be beneficiaries, though in different ways, from the liquidity injections that followed the credit crisis. These sectors had been among the best performers and exhibited some of the most consistent uptrends from the 2008 lows. However commonality deteriorated from July.

Following the credit crisis capital goods companies benefitted as infrastructure development was prioritised and abundant liquidity was made available. Consumer shares prospered as low interest rates and liquidity allowed Asia and Latin America to avoid the worst effects of recessions in the USA and Europe. From July 2011, as the Eurozone's debt crisis became the focus of attention and investors began to lend more credibility to the chances of a recession, shares most dependent on GDP growth experienced some of the deepest declines.

Let us compare Siemens with McDonalds:

Siemens experienced a sharp decline during the credit crisis; falling from a peak near €110 to a low near €33, It broke out of its base in August 2009 and posted a rivetingly consistent step sequence uptrend until early 2011. Prices broke sharply lower in July and have since steadied above €60. A short-term progression of higher reaction lows has been evident since September and the share has almost completely closed its overextension relative to the 200-day MA. The weaker Euro and increasingly more assertive attitude taken by the ECB towards the Eurozone's debt crisis are positive for companies like Siemens. If the medium-term upside is to be given the benefit of the doubt prices will need to sustain a move above €80 and continue to hold the progression of higher reaction lows.

McDonalds is also globally present but fell less during 2008 and was among the first companies to post a new all-time high in 2010. It remains in a consistent medium-term uptrend where overextensions relative to the 200-day MA of approximately $10 have generally been followed by reversions towards the MA. The share posted a large key day reversal on Tuesday and appears to be working on a weekly key reversal. The gap between the price and the MA is also approximately $10, suggesting the likelihood of a reversion has increased considerably. Nevertheless, a sustained move below the MA, currently near $90 would be required to question the consistency of the medium-term uptrend.