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Analyzing August's key industrial economic data

Analyzing August's key industrial economic data (Part 1 of 5)

Business inventories rise slower than sales, good for activity

Business inventories and sales data help predict economic activity

Business inventories are important drivers of the economy, especially when they build. Historically, recessions start with a buildup of inventory, which causes businesses to slow production and layoff workers. In fact, most recessions up until the Great Recession followed the same pattern. Economic activity increases, which causes inflation. The Fed raises interest rates in response to increased inflation, business activity slows, inventory builds up, and workers get laid off. Once the inventory is worked down, the workers are re-hired and another expansion begins.

Business InventoriesEnlarge Graph

While the Great Recession was caused by an excess of debt, business inventories are still important to watch. It’s essential to focus on the inventory-to-sales ratio, as spikes in this ratio portend slow-downs. “Normalcy” is defined as a ratio of around 1.25 to 1.35x. In early 2009, the ratio spiked to 1.48. Inventory buildups can cause temporary slow-downs in the context of an expanding economy, so it pays to watch them.

Inventories and sales rise in August

Sales were up 0.6% month-over-month in August, while inventories increased 0.4%. The inventory-to-sales ratio fell slightly, to 1.28. This is evidence that inventories are being worked down, which bodes well for future production.

Implications for homebuilders

Homebuilders are highly sensitive to the economy. Any sort of slowdown can leave them with excess inventory, and if home prices don’t rise, builders are stuck with depreciating inventory that costs them to maintain and finance. They will look at the recent business inventory numbers as indicating the economy is continuing to recover. Until we see inventory-to-sales ratios spike, they will see nothing in the inventory data to suggest caution—and certainly nothing to suggest that mass layoffs are on the horizon.

Homebuilders have experienced quite the renaissance over the past year as prices and activity have rebounded. Rising real estate prices seem to be driving increases in orders. As the economy improves, renters will begin to become more comfortable with the idea of homeownership. Given that the cost of renting is way higher than the cost of owning, marginal increases in the overall state of the economy and confidence will drive home demand. Housing starts have been highly depressed since the real estate collapse and even a small improvement in the economy will drive activity higher. Specific homebuilder stocks that will be positively affected by changes in consumer confidence include KB Home (KBH), Lennar (LEN), NVR Homes (NVR), Standard Pacific (SPF), and Toll Brothers (TOL).

This series focuses on industrial and manufacturing releases that will affect the real estate sector. Since homebuilders are highly cyclical, housing analysts watch the manufacturing data closely.

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