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Wednesday, March 10, 2010

Explaining Inventory Rebuild

I received a comment asking for better clarity as to why this morning's Wholesale Sales / Inventories report may be good news (stronger sales, less of a freefall in inventories)... before I dive in, please note that the below assumes all the figures are real (i.e. adjusted for inflation, which they are not). Here goes...

First the Legend

Red = Wholesale Production (rolling three month change); as measured by three month change in sales +/- the three month change in inventory (if inventories increase, then production = sales + change in inventories as some production was used to add to inventory levels).

Blue = Wholesale Sales (rolling three month change)

Orange = Variance between the two



As can be seen there was a negative feedback loop when the initial financial crisis hit that resulted in sales falling AND actual production plummeting (business just sold out of inventory rather than re-order stock) due to all the uncertainty (the initial decline likely caused sales to drop further as businesses stopped receiving new orders, which caused production to drop even further....)

The good news (now) is that when the inventories stopped freefalling, production levels actually ramped up faster than sales as new orders flowed right through inventories. As detailed at the top of this post, production is calculated from sales +/- the change in inventory, thus as long as the negative change in inventories becomes smaller (it doesn't need to grow), the production level increases relative to sales (which it did starting last summer and is now ~5% higher than actual sales).

This led to a huge amount of the GDP growth in Q3 and Q4 (~2/3 of all growth in Q4 was inventory rebuild). My whole point is that the sales level is actually showing decent growth too, thus the base (ignoring inventories) for production is growing. Add to that base any incremental impact of an actual inventory rebuild and you have the makings for some very good news.

Source: Census