Inventory Behavior Shows Businesses Are Still Reluctant

by: Robert Brusca

Business cycles, recessions and recoveries, are often linked to inventory behavior. From inventory behavior we can learn a lot about what firms think, when they make mistakes, and how confident they are. The inventory relationship is often termed the accelerator because when the economy turns up business sales rise, depleting inventories and reducing inventory-to-sales ratios. Firms wanting to maintain a target ratio of inventories to sales find their target missed and arrange more stockpiling leading to more domestic production or imports to fill the need. If domestic production is geared up, we get the accelerator result.

As demand picks up the need to produce increases faster as inventory levels are found wanting for two reasons: the unexpected sales acceleration reduces the level of inventories firms tried to build as the sales level outstrips expectations, and this erodes the I:S ratio from both the numerator and the denominator. This process works in reverse as well and is one of the factors that can make downturns deeper.

Apart from recessions and booms the inventory cycle plays out in a smaller way whenever the economy is changing speeds. Firms are always guessing about future sales and trying to hold inventories in balance; sometimes they get it right and sometimes they get it wrong. In the modern economy with better information and point-of-sale inventories as well as just-in-time inventory techniques a lot has been done to reduce the economy's reliance on a stock of goods. Still, getting the desired stock-to-sales ratio right is an ongoing battle and a factor in the economy's performance.

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The table above looks at inventory and sales performance by sector since that is more how it matters. We look at the dynamic version of I:S ratios by matching up inventory growth rates to the growth rates of sales over various periods as well as by assessing the overall current ratio of inventories to sales against an historic benchmark, its five-year range.

The table shows that inventories have behaved with moderation. The growth rate of sales by sector has exceeded the growth rate of inventories by sector over 3 months, 6 months and 12 months, with only one sector-horizon exception. While inventories are up by 7.7% in nominal terms over 12 months, sales are up by more, by 8.9% and so the inventory-to-sales ratio has been falling overall and by sector.

While inventory behavior can change it is likely that in this environment where both inventories and sales are advancing this lagging inventory growth rate has left stocks somewhere in most merchant's comport zone, but then we have survey data we can use to check that.

When we look at inventory-to-sales ratios directly we find the ratios are moderate to low. Total inventories' ratio is in the lower 4 percentile of its five-year range. Manufacturing inventories' ratio stands in the 55th percentile of its range. The retailing inventory ratio stands at the bottom of its five-year range. Wholesalers have the ratio in the bottom six-percentile of their range.

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Surveys reinforce this story - sort of. The just released NFIB survey (a survey of independent businesses) shows that the response 'inventories are too low' rose one point in the January survey and that the survey value for January is relatively high valued standing in the top 30% of its range. Only 30% of the time do respondents say that inventories are 'too low' with a greater propensity than they have in January 2012. Even so, the same set of data on inventories can be muddled. The NFIB also asks if firms are planning to add to inventories, a much stronger test of their assessment. This metric fell in January and its standing is in the bottom 40% of its range of responses. Turning to current behavior companies reported that they actually were adding to inventories as their response about current inventories desired rose by three points, leaving it near the mid-point of its range.

What all this tells us is how cautious business still is. Part of it is that business sales are growing but not accelerating. Sales were up by 8.9% over 12 months then cooled to a 6.9% rate of growth over 6-months and 3-months. Even though inventory growth has remained consistently slower, firms are not actively trying to expand their inventory-to-sales ratios even though the ratios are at/near historic low points in many cases.

Surveys on what firms think, what they plan and what they are actually doing with inventories give us somewhat disparate notions. In this environment where recovery -real recovery- has been slow to show its hand, that is not surprising. Business probably sees itself still in a wary survival mode more than in a profit maximizing competitive cauldron. Expectations for the economy to improve moved up significantly in January in this very survey but the net level of expectations still only resides in the bottom 30% of its range. Desired inventories are low because perceived economic performance is still unsteady.

Our actual inventory data are though December. The NIFB results are through January. Our employment report numbers bulged in January, but had started to look a bit better over the last several months. Retail sales, which advanced in January, still are not what we would call strong. That probably means that firms are establishing their behavior in a framework that is probably more 'game theory,' than 'profit-maximizing.' Some are still probably trying to make sure they do not make a decision that causes the worst result if the economy weakens instead of growing; firms are not going for all-out profit maximization on their best-case forecasts. In this environment a firm may have a best-guess forecast but may not be willing to put much stock in it. This interpretation seems consistent with the NFIB responses as well as actual inventory behavior. The economy may be turning the corner, but not fast enough to change minds - yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.