Monday, February 1, 2010

What Normally Happens to GDP After Blowout Inventory Quarters?

An interesting analysis in Bloomberg on what normally happens after huge inventory adjustments upward within the Gross Domestic Product.  I specifically did not mention last Friday's GDP because it's all hot air to me - for example the GDP deflator, a measure of inflation, came in at 0.6% versus 1.3% expectation.  I assume the GDP deflator never has to shop for health insurance, energy, tuition, or goes grocery shopping. That variance of 0.7% between what the government says inflation is, and the economists' expectation directly adds to GDP, overstating it.  (not that the economists' expectation is the truth - but the figure is below what America uses as official inflation, CPI - which is itself a highly flawed data point). [May 22, 2008: Bill Gross - Inflation Underplayed by Government]

We have seen the same tricks in previous quarters, in fact in 2008 we saw the folks who compile GDP use completely different inflation data than the government arm that measure inflation!  (of course in the GDP it was lower, which helped boost GDP).  This and many other such tricks makes analyzing government data a mostly useless exercise so other than acknowleding the data and knowing the market lemmings believe it to be gospel, I refuse to waste too much time on "garbage in, garbage out" which has turned mostly into propaganda.  ("you can't handle the truth!")  Part of creating solutions to problems is first admitting you have a problem - which our government reports have been "adjusting away" over the years.  [May 10, 2008: Finally Some Mainstream Reporters are Figuring Out the "Spin" from Government]    Or they just make the inconvenient reports disappear citing .......(wait for it.....) "high costs". [Apr 23, 2008: Barry Ritholtz on Disappearing Economic Indicators]. All part of living in The Matrix.

On a tangent, this Friday we have a once a year adjustment to (un)employment data - last year at the time the US government suddenly found (under rocks) about 850,000 unemployed that were "missed" during the monthly data.  Which in English means, the government admits they understated unemployment by about 70,000 a month.  Of course these people were not missed in the Trimtabs data - which people ignore while worshiping at the temple of D.C. statistics.  [Dec 6, 2009: TrimTabs Continues to Dispute US Government Payroll Data]  So all those months we bought stocks in fervor on the "better than expected" labor data were proven to be a mirage - but don't let that stop us from doing it again.  I would expect another 3/4 of a million+ Americans to suddenly find themselves unemployed this Friday - at least in the government's eyes.

But I digress.  While it must be taken into consideration there is so much stimulus flowing into the economy via government that all this data represents nothing of the real organic economy [Nov 18, 2009: Our Economy is on Steroids] - there were some interesting data points in the Bloomberg piece on how incredibly important inventory adjustments are.  I was not even aware of this myself.  Since everyone believes GDP is some magical measure of "economic health", this story highlights how something that represents just 1% of the output of the US can swing the GDP figures by huge amounts.  Consider this another grain of salt, only revealed to those who like to look behind the headlines (an increasingly small amount of people).
  • When is quarterly gross domestic product growth of almost 6 percent bad news? When it looks like what was reported last week.   U.S. GDP increased 5.7 percent at the end of last year, with more than half of that growth -- 3.4 percent -- attributable to changes in inventories. This astonishing impact of inventory has ample historical precedent, and the bottom line has terrible implications for 2010.
  • Inventories are a remarkable corner of the economy. They are the goods and materials that companies keep on hand to make sure that their operations run smoothly. They are the boxes of food on shelves at the grocery store and the bins of metal parts sitting next to the assembly line in a manufacturing plant.
  • Inventories were a big part of the story during the worst of this recession, and that is nothing new. In a landmark paper published in 1980, Princeton University economist Alan Blinder found that inventories, while accounting for less than 1 percentage point of national output, accounted for 37 percent of the fluctuations in output. (that's staggering)  Since Blinder’s paper came out, inventories have held onto their important role. Updating Blinder’s calculations through the fourth quarter of last year, inventories have accounted for about 34 percent of historical fluctuations in GDP since 1947.
So 1/3rd of the GDP is based on 1% of the output... think about that for a moment when you see how much importance we place on this data point.
  • Inventories are even more important during recessions. In another paper, co-authored with Louis Maccini in 1991, Blinder found that 87 percent of the decline in GDP from the peak to the trough of the recession was attributable to inventories.
Even more incredible.
  • Something that constitutes a small share of GDP can have a big impact on its overall volatility only if it is swinging about wildly. Inventories fluctuate so much for a simple reason: Predicting the future is really hard.   A firm tries to set its inventory level to match expected future sales. It must balance the financial cost of carrying inventoried items against the risk that customers might not find the product they are looking for.
  • In good times, inventories are relatively easy to manage. Demand grows a little bit each quarter, and firms have a good idea what their future sales will be.   Around turning points, expectations can go horribly wrong, and inventories are often the first sign that firms are being surprised by their customers.
So what has historically happened after large GDP jumps based on huge swings in inventory, as we just saw Friday?
  • Since 1970, there have been nine quarters, like the last one, when GDP grew by at least 3 percent and inventories accounted for at least half of that growth. The history of those quarters is hardly a favorable sign of what is in store.   Inventory spikes make for blowout quarters. In the nine quarters with such spikes, the average growth rate was 6.6 percent and the average inventory contribution was 4.4 percent, even higher than what was observed for last quarter.
  • Spikes also produce hangovers. The average growth rate in the quarter after a spike was 0.9 percent, a whopping 5.7 percent lower. In the second quarter following a spike, the average growth rate is just 1.6 percent.
History rarely repeats, but it generally rhymes.  People are asking how the market can sell off with such "good data" as we saw Friday.  One reason is those GDP figures were most likely the peak for this cycle.

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