Skip the Scratch

Story Highlights:

• Amid the economic weakness, we noted the downturn's first sharp rise in inventories in the fourth quarter.
• In past recessions, fast-rising inventories would signal the economic contraction was just beginning. And the eventual peak, though signaling recession's end, would be painful.
• This recession differs significantly from past slumps—inventories compared to sales have been falling for years and, added to that, firms started paring back early.
• Although the onset of the recession was intense, the private sector's reaction to last fall's panic may actually have lessened the recession's overall duration and severity.

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A broken record, a skipping CD—seems today's poor economic news is just about as repetitive. But given last fall's sharp financial panic, a deep scratch preempting progress isn't unexpected. Added to a bevy of negative economic headlines, we learned last week GDP declined in the fourth quarter. A painful outcome? Certainly. Will it get worse before it gets better? Likely. Will it last forever? Don't bet your shirt on it.

Amid the economic weakness, we noted the fourth quarter witnessed the downturn's first sharp rise in inventories. (Previous quarters saw declining inventories.) In past recessions, this signaled economic contraction was just beginning. Because business monitoring technology was less developed then, declining sales caused inventories to rise steeply for extended periods before firms took notice. When businesses finally did act, they moved quickly and dramatically to cut orders. Fast-falling inventories would lower margins and precipitate the worst stage of the recession—the last throes.

But one feature of this recession, not widely recognized, differs significantly from past experience—inventories have been falling for years. The recent downturn started with lower inventories as a percent of sales than at almost any other time in recent history. Further, expecting the worst last year (and far more adept at inventory management these days), firms pulled back business and began trimming inventory investment early. So, although the onset of the recession was intense, the private sector's halting reaction to last fall's panic may actually have lessened the recession's overall duration and severity.

Of course, there's no way to know when exactly the economy bottoms, but this gives us reason to believe the severity and duration of the downturn won't be as intense as is widely feared.

Either way, we expect dour news to continue skipping like a broken record. But stock investors needn't let the static hurt their ears—historically, markets have tended to fast forward past the scratch well before the headlines do.