Why investors should follow November's manufacturing data

Part 2
Why investors should follow November's manufacturing data (Part 2 of 5)

Business inventories tick up, but they’re still at a normal level

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 lay off 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 October

Sales were up 0.5% month-over-month in October, while inventories increased 0.7%. The inventory-to-sales ratio rose slightly, to 1.29. This is evidence that inventories are being worked down, which bodes well for future production. The GDP report showed that third quarter GDP rose by a larger-than-expected 3.6%, annualized partially due to inventory build. We can see that the inventory build continued into the fourth quarter. If demand doesn’t increase enough to absorb this inventory, then we could see a drop in fourth quarter GDP growth.

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. This should be a positive for homebuilders like Lennar (LEN), KB Home (KBH), Standard Pacific (SPF), Toll Brothers (TOL), and PulteGroup (PHM).

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