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Here's why the rise of this recession indicator might not indicate a recession

Nov 14, 2015, 16:33 IST

Here's an under-covered but very interesting economic data point: the Census Bureau's inventory-to-sales ratio.

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Right now, this ratio is spiking, indicating that businesses in the US are accumulating a stockpile of goods (this ratio measures how many months it would take businesses to sell down their current stash of stuff).

So the most basic question to answer is: are these inventories being accumulated because businesses can't sell these goods or because they're anticipating selling them soon?

First, here's the chart.

FRED

Of course, the answer to this question can probably be successfully argued both ways.

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There are a lot of economic indicators out there that folks will bandy about as "recession indicators," but a build-up in inventories showing that the economy is starting to roll over - or rather, that consumer demand is drying up - is, to my mind, a valid concern. And so seen this way, there is at least some reason to view the build-up in inventories with an eyebrow raised (as it relates to the health of the US economy, that is).

But if businesses think that the long-awaited surge in consumer spending that's supposed to follow the decline in gas prices over the last year is finally coming down the pike, then it would make sense to be prepared to this influx of spending. Or more accurately, it made sense three or six months ago to increase futures orders in anticipation of a big holiday shopping season.

The Wall Street Journal's Jeffrey Sparshott noted on Friday that this build-up is, at the very least, a negative for fourth quarter GDP as the value of the unsold goods need to be subtracted from the stuff that is sold, creating a drag on overall growth. Sparshott's analysis broke down various sectors, showing that manufacturing inventories have slowly creeped up, wholesaler inventories spiked right around the new year and have leveled-off, while retail inventories have been grinding higher for a few years.

The Financial Times' Matt Klein added that former Fed chair Alan Greenspan used to attribute the long-term decline in the inventory-to-sales to increased efficiency in corporate supply chains.

Greenspan's view, of course, makes intuitive sense and, with a cursory look at the data, seems to make empirical sense. The inventory-to-sales ratio, for example, rose to about the same level it was in 1996 - when the US was enjoying one of its longest economic expansions - at the height of the financial crisis.

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And so Klein's question was basically, if Greenspan's thinking about this ratio was broadly correct, what does this reversal imply?

For a potential answer, let's just look at retail sales and accept we're looking at only part of this phenomenon.

A thought I put to Klein is perhaps the inventory build is related to e-commerce companies keeping more goods on hand because online customers not only demand more choice but have plenty of alternatives if their desired good is not in stock.

Here's an example: say you're looking for a very specific pair of boots at Nordstrom that are out of stock. To find this pair of boots, you might then look to Macy's as an alternative.

Wikimedia Commons

(Earlier this year some experts were arguing Macy's could use its stores as "flexible warehouses" and, through these channels, become a serious threat to Amazon. The stock performances of these two companies this year tells a different story.)

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But so when the unfulfilled Nordstrom customer goes through the buying process at Macy's it isn't just the sale going from one retailer to another you need to think about.

This customer might find something else they didn't know they wanted, then get some sort of multiplier sale (like a "Buy $150, get $25 off" sort of thing), get free shipping, and so on. This all not mentioning Nordstrom's competitor now has their potential customer's email, payment information, and an idea of how they could be enticed to shop there in the future.

Nordstrom's has, in this example, not only lost a sale but lost valuable customer information and potentially future sales. And all because it didn't have the boots you wanted in your size.

So thinking about the retail industry through the lens of finding and retaining customers at all costs, it makes (some) sense to keep more stuff on hand. Though strategically you would seem to risk sending yourself down the rabbit-hole of loading up on inventory to find customers that may or may not materialize and/or doing the old, "sell a dollar to make 95 cents," hoping to make it back in the future (this is generally a bad plan).

Let's then think about the e-commerce elephant in the room: Amazon.

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Getty Images

Amazon has been a pioneer in cutting down on price, cutting down on delivery costs and waiting times, all while upping the quantity and variety of goods available by a very significant amount.

Thinking about the retailer's Amazon Prime offering - which promises free two-day shipping on any eligible goods - having lots of stuff quickly available to send all over the country would, necessarily, require a lot of inventory. Amazon is also planning to expand this network.

But of course the Amazon effect is not just about Amazon. This is the phenomenon that analysts writing about retailers like Nordstrom reference as sort of the catch-all for the idea that customers who shop online can get more or less anything they want, anytime they want it, and without a lot of effort find the best price.

And so as competition in this space multiplies - again, recall the earlier hypothetical with Nordstrom and Macy's: the sale, the data, the future sales, and so on - retailers, it would seem, have sought to invest more in having the merchandise available for the ever-more-fickle customer.

Earlier this week we wrote about why retail, but specifically brick-and-mortar, is such a brutal business. Among these factors was the fickle nature of customers.

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Brands are in and then they are out in the blink of an eye. As a retailer in this situation you're stuck with inventory, which you're then forced to sell at a discount (perhaps even a loss), only to find your brand is popular again in a few years but you're under-stocked in the item that sort of catalyzed your return to popularity.

Again, this is hard.

And so what we know is that the inventory-to-sales ratio is at a multi-year high and on an uptrend. What this means is that the amount of goods businesses have

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