Whether I’m looking at stocks or economic data, I try to let the information tell me its story. I blogged about inventory levels back in November (see here). The data are not much different, but I don’t like that they’re getting incrementally worse. Here’s the story that data are telling me:
Companies report sales numbers. In a steady state, there are similar sales down the channel (let’s pretend we’re looking at manufacturing of cars): A supplier makes one part and sells it to the car assembly company. The auto company uses that part and makes one car and sells it to the dealer. The dealer sells the car to the end user.
If at every level one unit gets sold, reported sales at each level reflect true demand. However, what if the car dealer buys two cars but only sells one…. The car dealership now has extra inventory. But the manufacturer may not know this. The manufacturer reports that it sold two cars.
Similarly, what if the manufacturer bought three car parts, but since it only sold two cars, one part now sits in the manufacturer’s warehouse. The supplier reports that they sold these three parts. The problem has now been compounded (remember that end-user demand was sale of a single car).
A mild recession occurs if various parts of the supply chain decide to work down inventory slowly. A big recession can happen if end-user demand slows down, forcing a big decline in sales all the way up the channel. Each level already has excess inventory. Just as the buying at every level was artificially inflated as inventory was building, the slowdown is magnified at each level when the inverse happens.
In terms of stocks, there is a direct implication for valuations. Imagine a company that reported sales of $100 and profits of $15. If the stock price is $150, the PE (price-to-earnings) ratio is 10x. What if sales were inflated, such that ongoing sales (reflecting actual consumer demand) were $90. Costs may not be much different than the earlier case, so that actual profits could be closer to $10 (or lower). The PE ratio therefore is not 10x but 15x. The stock that looked cheap is found to be expensive.
I’ve highlighted recent economic data points that give me pause; this is yet another meaningful one.
Business Inventories to Sales ratio — 5 year chart
Business Inventories to Sales ratio — 20 year chart (note: inventory levels have generally declined since the 1990s due to just-in-time inventory & supply chain management)