Defining "Inventory"

 

We are interested in how current commentators make a facile link between micro and macro-economics. The problem is that they think micro, and speak macro.

Micro helps with the supply curve.  And the demand curve.  Where do they intersect?

Honeymoon in Vegas:  Inventory?

Getting away from traditional thinking is difficult.  Sometimes it helps to start with an outrageous example.  My nomination is Sarah Jessica Parker in the movie, Honeymoon in Vegas. This movie is a lot of fun -- well worth the DVD rental.  The basic plot is that a guy wins $65K in a poker game (contrived) with another guy and agrees to cancel the debt for the creditor's weekend with his financee.

Simply put, she was not "in inventory" before this offer.  But everything has a price -- maybe.  Roger Ebert is our go-to guy on movies and he gave this one 3 1/2 stars.

The point?  There is always "inventory away from the market."

Application to Stocks

There is "inventory" of any stock.  Let's take Apple, Inc. (AAPL) as an example.  It is a stock which we own for both individual accounts and institutions. Let us suppose that our fair value for Apple is 220.  We would be sellers if that level were approached, and buyers at a lower level.  We have a wide market.  Other Apple investors have different markets.  Each day's trading reflects the current market for the stock.

The individual demand and supply curves are a function of microeconomics.  The intersection of the curves is a macro phenomenon.  To understand stocks means knowing both.

Application to Housing

The current discussion of housing seems to confuse the micro and macro.  There is much attention paid to housing that is "in inventory." Today's report on home sales and prices provided the information that there is currently a 10.6 month supply, arrived at by taking homes offered for sale and dividing by the current annual rate of sales.

The consensus interpretation of these data is that these homes will remain on the market until sellers get more realistic about pricing.

Errors in this Approach

The standard approach to the housing market has two conceptual errors.  Let us illustrate this by looking at our own neighborhood, consisting of four-bedroom homes with family rooms, fireplaces, large master suites, dens, and a community geared toward safety for kids and good schools.

As children get older and leave for college, the empty nesters offer their homes for sale.  They have a price in mind, but they are not forced sellers.  They may be thinking of buying a retirement condo at a similar price.  There are other sellers who have new jobs in another community.  They are more motivated sellers.

Let us suppose that homes are selling at a price of $500 K.

The inventory errors are twofold and conflicting:

1. It understates inventory "away from the market." Some (non-motivated) sellers have offers at $550 K.  These homes are not trading.  If prices approached this level, there would be a lot more inventory!  Many people who know that the price is unrealistic have not listed their homes, but would do so if prices moved higher.  This suggests that the quoted "inventory" figures are understated.
2. The analysis assumes static demand.  The measurement of inventory depends upon the current rate of sales.  Anything that influences demand would dramatically change the months of supply.  The demand curve would respond to several factors, including a perceived stabilization in pricing, strong government programs to aid buyers, or improved availability of mortgages. There may be buyers at current prices if conditions changed -- a shift in the demand curve.

Analysis

Many observers have noted that potential buyers are concerned about falling prices.  They fear that buying now will leave them under water in a few months.  These people are qualified buyers who are not willing to "pull the trigger" until they see stability.

The demand picture is also influenced by the limitations on available loans.  Any moves to increase lending power -- more capital for lenders or a resumption of securitization -- will shift the demand curve.

Higher prices will bring out more sellers.  There may be much more inventory at higher prices -- inventory not reflected in current listings.

Conclusion

The typical analysis one sees in the financial media takes a superficial approach.  It assumes that all inventory is "real" and does not consider either "latent supply" at higher prices nor "latent demand" at curent or lower prices.

Investors interested in housing problems -- and we all should be -- must consider how both supply and demand curves will change in a dynamic environment.  Looking only at the apparent supply, and assuming that sellers will eventually reduce price offers, is a mistake.

We are not selling Apple at 185....

Any analyst not looking at both supply and demand curves, and potential shifts, is not giving a complete picture.

Comments

[nukldrager:]

Where can one find the supply and demand curves for the country, and states individually? I liked the article, but would like to see data for both curves to better understand.

2008 May 28 08:32 AM

[nukldrager:]

Are you saying that something is in inventory when there is an offer on it?

2008 May 28 08:35 AM

[jjason:]

Jeff, You are comparing Apples to housing? Oh my!

I know you are trying to explain how to count inventory. But it may not be possible in housing to get it right.

I was a real estate broker. Some of the market statistics I looked at were: # of days on the market, # of price reductions, number of listings, # of solds per week, month and year and vacancy rates.

Then, as an appraiser I looked for comparable sales. In the S&L crisis in 1990 to about 1994 sometimes I could not find any decent comparable sales in the neighborhood or in the town or in nearby communities to use to establish a value for the subject property.

Both jobs gave me the knowledge of the market that came from actually seeing what was going on.

I could not believe how bad the real estate market got between 1990 to 1994. It is just as bad, if not worse in many markets today.

2008 May 28 12:30 PM

[Julie:]

Interesting theory but there's a lack of hard data to provide any other useful inventory number. Is the current inventory number completely accurate? Certainly not! Your analysis is reasonable except for providing a realistic way to provide a better number.

2008 May 28 03:57 PM

[Observor:]

Yes, inventory is a dynamic number. It reflects the changes in supply and demand relationship. In skewed market condition, demand was scare away, and supply eager to sale; the inventory will appear extraordinarily high. The opposite can be also seen. In another word the current inventory is not a reliable number to determine if buy or sell a house for long term plan. For buyers you want buy a house at the highest inventory level, which will ultimately benefit you in long term even you may take the roller coaster. For today’s environment, it is especially interesting: if you remove the housing out of the picture, the economy is actually doing very well. Even the high energy that helps create a lot of new jobs. On the supply chain, the new home build plunged 16 year low. The market is full with foreclosed homes, which is creating huge supply deficit for next a few years (those families are driven out of their homes now). Our population is growing at all time high. US population has already passed 300m, which is a pivotal point. What the big picture is? In the near future, housing will boom even stronger than before, not like the media scaring people. The media try to create huge opportunity for bigger investors not for ordinarily people like you and me.

2008 Jun 04 11:02 AM