Richard Russell’s Dow Theory Letters dated March 20, 1970:
“Sales and Inventories: The accompany chart from the Journal of Commerce (thanks to Humphrey Neill) shows an interesting picture, the critical sales to inventory ratio. When business is expanding, and we note on the chart that the long upward rise in the FRB production index [Industrial Production Index] signifies that it has been expanding, manufacturers tend to become increasingly bullish. Consequently, they also seek to build up their inventories in anticipation of increasing business (and as a hedge against inflation.)
“Then, as a slowdown in sales appears, it usually catches manufacturers either unaware or unable to adjust their inventories fast enough. Those who see the slowdown coming may cut back their inventory building in anticipations. This is termed to voluntary inventory cutting. But in most cases a belated recognition of a sales slowdown hits manufacturers. Then they are faced with a problem; sales are declining, and they have far too many goods coming in on order. The next step is canceling unwanted orders and cutting back on future orders. This is the process known as in voluntary inventory cutting, and it is undoubtedly happening now (page 5).”
We’ve updated the Inventory-Sales Ratio by comparing it to the Industrial Production Index with year-over-year percentage change in the chart below.
Worth noting is that the Russell comparison shows the Inventory-Sales Ratio on an inverted basis making a decline in one to also appear as a decline in the other. Our updated view, showing year-over-year percentage change, is the best way to make the comparison on a relative basis and reflects an inverse relationship between the two indicators.
In the period from 1992 to 2019 (only available data for comparison), when the Industrial Production Index had a decline into negative territory, coincides with the beginning of a recession except in the period of April 2015 to December 2015. As we’ve stated in the past, we believe that the period from 2014 to 2016 was a recessionary period that was not indicated by the National Bureau of Economic Research.
Finally, notice that in the period from June 2018 to December 2018, the Inventory-Sales ratio has seen a dramatic spike from –4.31% to +2.98%. Combining such a dramatic increase in the Inventory-Sales ratio along with the peaking of the growth rate in the Industrial Production Index could mean a recession in 9 to 12 months from now. This was generally the pattern prior to the 2001 and 2007 recessions.