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. This 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 the 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, it’s still important to watch business inventories. It’s essential to focus on the inventory-to-sales ratio because spikes in this ratio forecast slowdowns. “Normalcy” is defined as a ratio of ~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 increase in July
Sales were up 0.8% month-over-month in July, while inventories increased 0.4%. The inventory-to-sales ratio was flat at 1.29. A year ago, the inventory-to-sales ratio was 1.28. In a robust economy, the ratio is usually in the 1.25–1.3 range.
The higher the inventory-to-sales ratio, the weaker the economy. The inventory-to-sales ratio peaked at 1.48 during early 2009.
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 increase, 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).