The Inventory Story

Monday 06/02/14

     {[1923.57, 11.66, 0.6098613428456283, 1134.5, -7.7, -0.6741376291367576, 3736.82, 13.75, 0.369318868568144]}     Last week stocks moved higher despite revisions to first quarter GDP that showed the economy shrinking by a 1% annualized rate in the first quarter instead of 0.1% growth. Many economists are now blaming the unseasonably cold weather in the 1st quarter and have dismissed it as a fluke. In fact, many economists revised their estimates for second quarter GDP even higher. I am not as quick to write off the miss simply because of bad weather though.
          There was a buildup of inventories in the second half of 2013 as businesses began to anticipate a stronger pace of growth, but that growth never seemed to materialize. This resulted in a boost to GDP in 2013 at the expense of negative growth in the first quarter of 2014. This week I want to look at the often overlooked indicator The Manufacturing and Trade Inventories and Sales Report (MTIS) and show how it can be used to predict consumer led economic weakness.
         GDP is the total amount of final goods and services produced. This includes inventories at businesses that haven’t yet been sold to the consumers. Business spending on inventories is included in the I (I stands for gross private domestic investment) portion of GDP. Businesses will boost their inventories when they expect strong demand for their goods in the future. Month-to-month changes in business inventories is not that interesting in the investment community, because it is often a lagging indicator. The chart on the right shows that business inventories fall steeply during recessions, but there doesn’t seem to be a clear warning sign before it happens. Sustained trends in business inventories are much more interesting and can send signals of upcoming weakness.
          A more useful measurement is the inventory-to-sales ratio. The inventory-to-sales ratio shows how many months, at the current sales rate, businesses have before inventories are completely depleted. For example, an inventory-to-sales ratio of 1.3 means that businesses have 1.3 months of inventories left at the current sales rate. A rise in inventories will increase this number and a rise in sales will decrease this number. The inventory-to-sales ratio trended down for many years until flattening out in the mid-2000s. This has been largely attributed to better inventory control practices. If a business receives smaller more frequent deliveries it will reduce the risk of being overstocked in a period of weak demand and strengthen its balance sheet because it doesn’t have to finance such a large inventory and can reduce warehouse storage space.
          Before the recession in 2001, there was over a year of steady monthly increases in the inventory-to-sales ratio from 1.38 to 1.45. This can mean that businesses are overstocking or that demand is not sufficient to lower current inventories. It could mean that businesses were overly ambitious in their forecasts or that consumer demand is slowing. In 2001, this was a sign of a consumer driven recession, however in 2008, there were no warning signs in the inventory-to-sales ratio. The recession in 2008 was a liquidity crisis which led to a tightening in financing that ultimately led to a sharp adjustment higher in the inventory-to-sales ratio.
          The inventory-to-sales ratio has risen from 1.25 in April of 2011 to 1.30 in March (the most recent data point) and was as high as 1.31 in January. This is roughly the same magnitude as the rise that predated the 2001 consumer driven recession. The trend is even clearer when it comes to the inventory-to-sales ratio of retailers and automobiles. I suspect that businesses ramped up demand in 2013 which boosted GDP growth above estimates, but since consumer demand was not high enough to meet those expectations overstocking led weaker Q1 GDP as inventory was drawn down. This certainly does not foretell a financial apocalypse, but it does reinforce the trend of consistently weak consumer demand that has plagued the current recovery. While it is certainly likely that weather played a role in weak Q1 demand, it seems clear that the story is much more complicated than that.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 192.68 0.85% 4.44%
IWM (Russell 2000 ETF) 112.86 0.15% -2.7%
QQQ (Nasdaq 100 ETF) 91.31 1.14% 3.71%

Business Inventories

Source: U.S. Department of Commerce

GDP Calculation

This shows the formula for calculating GDP.

Inventory-to-Sales Ratio

The inventory-to-sales ratio shows the number of months of inventory remaining at the current pace of demand.