Wednesday, April 8, 2009

Another Reason For Optimism: Inventory Cycle Speeds Up

Wholesale inventories, which account for about 25% of all business inventories, fell 1.5% in February, the sixth straight monthly decline and the largest decline since January 1992. Sales increased, by 0.6%.

The combination of falling inventories and increased sales brought the inventory-to-sales ratio down to 1.31 months from 1.34 in January, although it is still well above the record low of 1.06 months set last June. The decline nonetheless represents progress, and U.S. companies have calibrated their output sufficiently to the new, lower levels of demand. It's encouraging to see good management at work; what's needed now is stimulation of demand.

This shift should begin to reduce the rate of decline in output, although no meaningful increase in output is likely until inventories are brought down significantly more. In other words, the trajectory is changing and it will change enough to perk up a variety of the factory-laden economic calendar, but the magnitude of change is not likely to be large.

A sector that illustrates the evolution of the inventory cycle is the automobile sector. U.S. manufacturers produced vehicles at a 4.3 million annual rate in January and February, well below sales of 6.7 million annualized. In other words, manufacturers have already made the adjustment necessary (hopefully) to fit the drop in sales they have experienced. In fact, in this case they have over-adjusted, and if the condition improves, production will have to rise.

It is the direction of change that will get attention first, via the factory-laden economic calendar. This will rally riskier assets, like stocks. Later, there will be focus on the magnitude of change and on whether the change in direction is enough to spark a change in the production cycle strong enough to take hold and evolve into a self-reinforcing virtuous cycle of increases in production, income and spending. There will be plenty of obstacles and plenty of doubts along the way; but the doubters may well be wrong this time.

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