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Don't Fret Yet About Rising Inventories

Companies adding to their stock-on-hand is a sign of confidence. Now it all depends on whether the recovery can get rolling again

Earlier this year, as the economic recovery was gathering momentum (rather than losing it, as has been happening lately), one of the nagging concerns was that companies were too slow to rebuild inventories. The ratio of business inventories to sales plummeted through the second half of 2003 and early 2004, even as sales took off. Economists called for an upturn in inventory restocking to show that businesses had confidence in the economy and -- importantly -- to make sure they had enough stuff on the shelves to meet increasing demand.

Careful what you wish for. Recent economic reports show that inventory levels at U.S. companies are finally rising. On Aug. 9, the government reported that wholesalers' ratio of inventories to sales climbed to 1.15 in June, up from a historic low of 1.13 in May. On Aug. 12, the Commerce Dept. will release its broader manufacturing and trade inventories and sales figures for June. Research firm Action Economics expects the inventories-to-sales ratio to climb to 1.31, from the record low 1.30 in May.

COMPUTER SHOCK. But suddenly, investors don't like what they see. Wachovia Securities' Larry Wachtel lamented in an Aug. 11 market report that the recent "soft patch" in the economy was attributable to "record energy prices and a high level of inventories." Some economists noted that the rise in the all-important ratio had more to do with stagnant sales than an increase in inventories.

Cisco Systems (CSCO) walloped the tech sector on Aug. 10, when it released a quarterly financial report that mostly met Wall Streets expectations (sales were up a stellar 26% over the prior year) but showed an uptick in inventories -- to $1.2 billion from $1.1 billion the prior quarter. It didn't help that Cisco CEO John Chambers noted that customers were increasingly worried about the strength of the economy. National Semiconductor (NSM) also spooked investors when it noted a rise in inventories while warning investors Aug. 10 to expect weaker sales for its quarter ending Aug. 29.

Of course, intentional inventory rebuilding is a lot more desirable than the unintentional kind. The slower inventory turn at those tech outfits is, not surprisingly, the kind of preliminary indicator many investors in this skittish market are all too willing to jump on. Both Cisco and National Semi fell more than 10% and the tech-heavy Nasdaq plunged 26 points, or 1.5%, on Aug. 11.

HELPING GDP. For the broader economy, the uptick in inventories is a positive sign. Inventory-to-sales levels are just now lifting off record low levels. That inventory growth is helping to fuel an economy that's currently grappling with a slower rate of consumer spending, says David Kelly, economic advisor to Putnam Investments. "There's nothing unhealthy about the growth in inventories we've been seeing in the last month or so," he says.

Mike Englund, Action Economics' chief economist, expects the inventories increase to result in an upward revision to preliminary second quarter gross domestic product, which came in surprisingly weak at just 3%. He expects GDP to be revised up to 3.2% -- and perhaps to as high as 3.5% if retail sales, also to be released by the Commerce Dept. on Aug. 12, are stronger than expected.

Joel Naroff, of Naroff Economic Advisors in Holland , Pa. , says the uptick so far is a much-needed stabilization. "It's a sign of confidence on the part of the business community," he says. "What [executives] had been doing before is saying, 'I can't be certain the expansion is real.'" Now, even if they aren't yet willing to invest in hiring, they're beginning to invest in an expected increase in future demand, he says. His only worry is that if the hiring picture doesn't improve soon, consumer demand could fall off sharply enough to halt the expansion.

REASON TO BE THANKFUL. Adds Putnam Investments' Kelly: "The broad picture is that American business is way too pessimistic. I don't think the inventories-to-sales ratio is high now. And if companies add to them, I don't think that's a bad sign."

With questions about the sustainability of the current economic expansion increasingly weighing on the market, it's not surprising that investors are worried that growth seems to have cooled in the past month or two. But instead of worrying about an accompanying rise in inventory levels, they should be thankful that businesses are at least willing to keep the shelves stocked.

Stone is a senior writer at BusinessWeek Online
Edited by Thane Peterson