Business inventories rise, while inventory to sales ratio is flat

Business inventories and sales data help predict economic activity

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

While the Great Recession was caused by excess 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 slowdowns. “Normalcy” is defined as a ratio of around 1.25–1.35x. In early 2009, the ratio spiked to 1.48. Inventory buildups can cause temporary slowdowns in the context of an expanding economy, so it’s important to watch them.

Inventories and sales rise in May

Sales were up 0.4% month-over-month (or MoM) in May, while inventories increased 0.5%. The inventory-to-sales ratio was flat at 1.29. In a robust economy, the ratio is usually in the 1.25–1.3 range.

Implications for homebuilders

Homebuilders are highly sensitive to the economy. Any sort of slowdown can leave them with excess inventory. If home prices don’t rise, builders are stuck with depreciating inventory that costs them to maintain and finance. They’ll look at the recent business inventory numbers as indication that the economy is continuing to recover. Until we see inventory-to-sales ratios spike, they’ll see nothing in the inventory data to suggest caution—and certainly nothing to suggest that mass layoffs are on the horizon. This should be a positive for homebuilders like Lennar (LEN), D.R. Horton (DHI), Standard Pacific (SPF), Toll Brothers (TOL), and PulteGroup (PHM).