Are Rising Inventories Good?

Two of the latest economic releases that caught my eye were wholesale sales and inventories, partly because sales fell off a cliff, but also because inventories did the opposite, rising significantly.

Sales at wholesalers fell 1.9% in January, the largest drop since 2009, and a lot of the blame, rightly or wrongly, was placed on the wintry weather. However, inventories still grew at 0.6% after an upwardly adjusted December gain of 0.4%, painting a completely different picture.

What do these two conflicting data points show us?

Inventories precede Sales

Inventories typically rise out of optimism as companies increase them in preparation of more sales. Companies generally buy inventory from the raw material and goods producers. Sales, on the other hand, are usually of the final product, the former inventories of a business that are eventually sold to the consumer or another business.

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Generally, rising inventories are good, as long as sales keep up.

However, if sales start falling while inventories continue rising it increases the risk of future write offs and mark downs as inventory becomes obsolete and businesses have to sacrifice price in order to eventually sell product. Such an event can warn of a change in the consumer’s (NYSEARCA:XLY) habits as there is too much supply and/or too little demand.

That is one reason why January’s numbers caught my eye. Wholesale inventories are significantly outpacing sales.

Autos – a Barometer of Total Inventory/Sales

Rising inventories can warn that corporations are either too optimistic about the future, or they are too focused on their own sales numbers that they partake in “channel stuffing” in order to make their own sales numbers. They pass on their inventory as sales to other businesses which then take it as inventory. Eventually, though, the gig comes up as the end consumer is ultimately needed to convert inventories to sales.

A popular metric used to track the health of inventories as well as help identify channel stuffing is the inventories to sales ratio.

The chart below tracks this through time in the auto industry and shows why investors should take note of the rising auto inventory/sales ratio as it likely has implications for auto stocks such as GM (NYSE:GM), Ford (NYSE:F), and Honda (NYSE:HMC).

In the chart below the automobile inventory to sales ratio generally stays between 2.0 and 2.7x. When the ratio gets outside these levels, as it has been now for two months, it should raise red flags to investors. When it is below 2.0x it often precedes an economic and equity market upturn, but when it is above 2.7x it often precedes sales slowdowns in autos.

Auto sales have been growing steadily per year since the 2009 recession bottom, finally in late 2012 surpassing the 15 million car level that has been associated with most other prior positive economic years.

But, the inventory to sales ratio now sits at 2.9x, one of the highest levels ever, and the chart displays why this should be viewed as a warning to investors. This ratio has only been this high two times in the past, once in 1995 and again in 2008 at the height of the last recession.

In December 1994, unit car sales peaked out at a six month average of 15.1 million units, one month before this inventory to sales ratio previously reached 2.8x. It took until 1998 before average six month sales started to climb meaningfully above that level again. Car sales were essentially flat for four years once the ratio surpassed 2.8x in 1994.

By the time the ratio hit 2.8x in 2008, the markets and auto sales were already in freefall, but it is clear that inventory was very overestimated in that instance as well.

If history is to be our guide then we could draw the conclusion that today either optimism of future sales is too high or the auto makers have been caught channel stuffing, either way, we should expect auto sales to slow in the coming months/years as inventory comes back in line with historical averages.

Here’s the good news: You should be able to get a great deal on a vehicle (NYSE:AN) today as dealers (NYSE:ABG) have more inventory than ever. And as long as this inventory to sales ratio keeps rising, these deals should only get better.

The ETF Profit Strategy Newsletter keeps investors on the right side of the trends by using fundamental, technical, and sentiment analysis. Auto sales are likely to slow down as the market is oversaturated with inventory and risks a pullback from the optimism that sits near historical highs.