Inventory Statistic May Hearken Economic Malaise Rather Than Rebound

And here is the early article from Feb 4, 2002 referenced above.

Feb 04 Deflating Inventory Mythos 6:00 AM
Once in a life time 'bargains' made +0.2% GDP possible
In recent weeks the commentary surrounding the U.S. economy has been palpable: the recession is almost over. Backing this buzz has been optimistic words from Greenspan, the end of the Fed's rate cutting campaign, and a spray of economic reports confirming 'the worst is over'. Is it really the case that the longest U.S. expansion ever will be proceeded by one the shortest contractions ever? Many think so, including the Conference Board, ECRI, and about 99% of participants at last weekends World Economic Forum summit. However, one unlikely speaker was not so sure. His name was Bill Gates:

"I don't see any big uptick in this year. Japan certainly won't be, and the U.S. won't be?There are still some companies out there based on the old (1990s) thinking. The sobriety will stay. The somberness will stay. It's very healthy ... I like this period where people are forced to play by rules driven by economic sense."

Admittedly, Bill Gates didn't specifically predict that the U.S. economic recession would continue through out 2002, nor did he forecast a great bear market, a stock market crash, or a U.S. economy/market that traces the steps of 1990s Japan. Rather, he was simply being cautious rather than overly optimistic: just because economic recession may be waning this doesn't mean the U.S. economy will soon be booming.

The Deflationary Recovery?

Announced last week:
Prices (GDP deflator) fell by an annual rate of 0.3% in the final quarter of 2001 (the largest drop since 1952), the future inflation gauge (ERCI) dropped to its lowest reading since 1975, and 89,000 more jobs were lost in the month January. Sounds like bad news, doesn't it. However, rather than focus on these ominous occurrences the press decided to disseminate 'news' in a different fashion. To be sure, here are the most newsworthy headlines last week: the unemployment rate fell to 5.6% from 5.9%, GDP growth rose in 4Q01 by 0.2% (-1.1% expected), and a myriad of other reports came in 'better than expected' (new home sales, consumer confidence, and durables). Dependant upon which numbers you focus on, last week marks either the imminent end to the shortest recession ever, or the continuance of corporate layoffs and deflationary woe (or perhaps both).

With this in mind, what should be noted is that growth is not necessarily a good thing for the U.S. economy: remember, the horrible earnings numbers recently reported by corporate America were tabulated from 4Q01, or when consumers were acquiring more debt to spend, spend, spend (+0.2% GDP!). Moreover, and despite countless claims that 'inventory reductions' are foretelling of an upcoming expansion, inventory itself acts a moderator between corporate American and working America ? it is not the facilitator of an immediate turn around. To be sure, debts acquired for Christmas gift giving that helped in lowering inventories could hinder spending near-term, and companies will remain unlikely to hire new people until they know they can turn a healthy profit (raise prices or productivity). As such, perhaps the biggest lie being spouted by countless analysts is that 'drops in inventory are a signal of a turnaround'. Generally stated, the decline in inventories in late 2001 coupled with weak earnings results tell us that companies sold product below cost, while consumers were eager to snap up bargains.

To read anything more into the inventory data is to promote a pre-determined bias of what you expect growth to be. Just as silly readings (January Effect, Super bowl Rule) are now quickly tossed aside by those who embraced them when the bull was charging, so too are inventory readings manipulated in the same fashion. Who among those claiming inventory reductions signal a pending economic turnaround predicted that the inventory rise in the late 1990s foreshadowed a severe economic slump? Did Abby, Goldman and Battipaglia tell us that the inventory overhang would cripple the economy? No. As such, is it that surprising that Wall Street heads, Fed members, politicians, and CEOs are encouraged by drops in inventory? Is it not their jobs to be encouraged first, and to find scraps of optimism to back their beliefs afterwards?

"The associated backup in inventories has induced a rapid response in manufacturing output and, with spending having firmed a bit since last year, inventory adjustment appears to be well underway".
FOMC Statement

No, this statement is not a quote from last weeks FOMC meeting. Rather, it is from the March 20, 2001 FOMC meeting. Clearly, talk pertaining to 'inventory adjustments' is not a strict science: here we are nearly a year later and 'well underway' is still the phrase of choice. A phrase that has proved utterly worthless to everyone concerned since early 2001.

Deflating Inventories

The biggest near term threat to the U.S. economy is deflation: deflation pummels profit margins, entices the consumer to spend when they perhaps shouldn't, and deflation tricks people into believing a sustainable economic recovery is on the horizon. In sum, while a deflationary environment has helped what ails the U.S. economy, few people would argue that continued deflation is a plus given its byproducts (potential for a liquidity trap, and poor profit margins).

Ironically, deflating inventories are not viewed with the same degree of skepticism as 'deflation' in general. Rather, if you speed up the pace of inventory reductions it is largely assumed that you speed up the timeframe needed for economic recovery. This is an odd theory given the fact that the new 'just-in-time' mantra (an efficient inventory killer) has gained prominence in recent years, and also that currently no CEO in America is predicting a lasting jump in demand. As such, could drops in inventories merely be a signal that corporate America is becoming more efficient, and less optimistic about the future? If so, would not a rise in inventories be more telling of an economic rebound? The deflating minds of investing America would like to know?

Strange Inventory Signals

Perhaps everyone was wrong back in early 2001 when they assumed that the inventory overhang would constrict economic growth. As it turned out, the best thing the U.S. economy had going for it late last year was beginning the quarter with 'high' inventory levels. That said, how long will people be able to get cheap loans to buy those dusty products sitting on the store shelf?

In this regard, it is curious why everyone is enthused by inventory reductions. But what is even more curious is why inventory reductions are presumably a bullish indicator for stocks. As total consumer credit exploded in late 2001 corporate America lost money. No one denies this fact. The end result is that the consumer now has dramatically less purchasing power today than in early 2001 (debt burden to disposable income). With this in mind, perhaps the only way to keep this enthusiasm going is for inventories to continue dropping. That said, even if this happens in order for enthusiasm to be sustained investors would have to continue to ignore earnings, and continue to believe that inventory drops artificially enabled by mass deflation are signs of a turnaround.

Only one thing is certain: inventory reductions are a signal that either the bargains are ending, or the demise in corporate profits is continuing. I will not try and tell you what this means for the economy. You already know that: deflating inventories can mean whatever you want them to mean.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.

October 19, 2003 Inventory Statistic May Hearken Economic Malaise Rather Than Rebound by Willett & Alway

Understanding the implications that business inventories have on the broader U.S. economy is a game of context. If you focus on the statistic in abstraction from longer term trends in the economy you can build a coherent argument that escalating inventories are auspicious in the immediate term. Contrarily, the same statistic situated within the proper long-term context emerges as less immediately promising. Since the former opinion is being trumpeted by The Street, it may be of some service to elucidate the latter opinion here. The Toyota Lesson In aiming to make the manufacturing process as efficient as possible, Toyota Canada does not keep more than a few hours worth of certain production materials on site. This type of 'just in time' inventory system can prove hazardous should there be some disruption within the transportation infrastructure, or even if trucks are delayed or packed improperly (i.e. with the product that is needed first being at the rear of the trailer). Nevertheless, the system usually works, and this is one of the reasons why the non unionized Toyota in Cambridge Ontario consistently ranks as one of the most efficient in North America. With Toyota's perpetually increasing inventory efficiencies in mind - and realizing that similar systems are (have) being duplicated by not only automobile competitors but by companies in other industries as well - it is not surprising that U.S. business inventories have been trending lower for more than a decade. What has facilitated this change - often referred to as increased 'productivity' - is not necessary higher/faster inventory turnover, but better management of existing stocks. This is an important point to remember, especially since economists are touting that 'inventory rebuilding' will add significantly to U.S. GDP in the coming quarters. The Not So Great Inventory Rebuilding Cycle In an attempt to smooth out the imperfect statistic that is inventories, analysts often point to the inventory-to-sales ratio as being a more reliable forecasting tool. The logic touted is that the future implications of inventory levels can be better understood if you consider the trend of sales in relation to inventories - higher/lower inventories do not necessarily mean anything significant for the economy unless the trend in sales is also studied. For the most part, the inventory-to-sales ratio has become standard fare. Accordingly, following this week's decline in September inventories (and a smaller decline in sales), the analysts came out of the woodwork to argue the significance of these dated statistics. Quoting just one of these analysts, the level headed Caroline Baum - in 'Shop in the Third Quarter, Produce in the Fourth' - we hear the standard line, one which sounds all too familiar: Highlights: -- Not only are inventories at an all-time low relative to sales, but accumulating them is also starting to make good business sense... -- All-consumer-all-the-time isn't a necessary prerequisite to sustain economic growth...Inventories could easily make a positive contribution to GDP growth in the current quarter and in the first half of 2004...Come the second half of next year, however, "we'll need to have job growth" to sustain the expansion. For those of you with a keen memory, you will recall that similar claims of an inventory rebuilding cycle were being touted in 2001 and 2002. To be sure, and as highlighted in a Feb 2002 Word on this site ("Deflating Inventory Mythos"), for more than a year the party line from the Fed - since March 2001 - had been: "The associated backup in inventories has induced a rapid response in manufacturing output and, with spending having firmed a bit since last year, inventory adjustment appears to be well underway". In March 2001 Sir Greenspan wasn't talking about inventories simply expanding. Rather, the Fed was giving a specific reason why the economy had slowed - slumping inventories - and was suggesting that a new inventory building phase was imminent. To be sure, in the two FOMC meetings following March 2001 the Fed included the statement "A significant reduction in excess inventories seems well advanced". And yes, at the time, bullish economists lapped it up. When the inventory build up did not arrive in 2001 the Fed stopped mentioning inventories. That is, of course, until March 2002, when the Fed tried to assure the markets once again that inventories were going to build: "The information that has become available since the last meeting of the Committee indicates that the economy, bolstered by a marked swing in inventory investment, is expanding at a significant pace." FOMC March 2002. Suffice it to say, inventories did not build up with any sustained vigor in 2002. Contradicting Common Sense? As forklifts unload automotive parts at Toyota, many are dropped directly into the assembly line. The term 'storage' and/or 'inventories' doesn't exist... With the inventory-to-sales ratio at record lows and the economy picking up steam inside of a low interest rate environment, a strong case can be made that inventories will be rebuilt in the coming months. Our viewpoint is not that this will not happen, but that the longer term trend of lower inventories puts this into a different, less bullish, context. Beyond the seasonally adjusted chart - which shows inventories-to-sales at all time lows, consider two alternative charts. The first shows the data without its seasonal adjustment, and points out the yearly cycle of inventories - with the inventory-to-sales ratio always peaking in January/February - while the next shows the long-term trend smoothed out using a 6-month trailing sales number. Most notably, the second chart should be studied by Greenspan and any economist excited about the prospects of a huge inventory build up. To be sure, the trend - even when the economy was booming in the 1990s - is for companies to maintain lower inventories in relation to sales, and this trend will not be reversed. Perhaps when Greenspan and company are touting the next inventory building cycle they should remember that their 'productivity' driven economy precludes inventories from ever building up like they did in the past.

Brady Willett & Todd Alway BWillett@fallstreet.com www.wallstreetwishlist.com « Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. »