Take Inventory of GDP Growth: There's Pain on the Horizon

Although the economy expanded at an estimated 2.5% rate in the first quarter, we're still in the midst of a tough slog, and recovery remains elusive. GDP missed economists' expectations of 3% expansion, and things still aren't going as smoothly as some had anticipated. As the year progresses, it's possible we'll see things get worse.

However, as my colleague Morgan Housel showed recently, you shouldn't necessarily base your investment decisions on that. There is almost zero correlation between what the economy has done (or is expected to do) and the returns of the S&P 500 . But don't ignore the underlying events, either. Stock valuations have been propped up by massive infusions of money into the economy by the Federal Reserve, and when the spigot is finally turned off, it could all come crashing down. Buying solid businesses at reasonable prices remains an important investing strategy.

Zeroing in on certain components of the GDP report, though, we see that the stockpiling of goods accounted for all the expansion realized in the economy. Inventories subtracted 1.52 percentage points from GDP in the fourth quarter of 2012 and then reversed course and added 1.03 percentage points in the first quarter of 2013.

Private businesses added $13.3 billion in inventories in the fourth quarter and $50.3 billion in the first quarter. As they fill up their stockroom shelves, it creates a hangover effect they need to correct for, and it ends up pulling back on the reins of production later on. While some of the buildup was necessary following the fourth-quarter draw-down, it may be tough for inventory to add much to the coming quarters. Inventory increases add to GDP, as we just saw; if they slow in the coming quarters, the numbers won't look so rosy.

According to the Institute for Supply Management, inventories in the nonmanufacturing sector got a big boost in February: The index jumped to 54% from 47% in January, but it fell back again in March, just as it did in the manufacturing sector, though the trend there was not nearly as dramatic. Although it seems things are cooling off already, it's worrisome that sentiment among inventory managers shows that they believe their inventories are still too high. As that outlook was spread across almost every industry, expect them to step on the brakes harder to bring inventory levels into equilibrium.

Inventory expansion and contraction is all part of the business cycle, and quarter-to-quarter moves can often add up to a lot of noise. But the magnitude of the change plus the drop in real final sales -- or GDP minus changes in private inventories -- from the fourth quarter to the first indicates that this is not a one-off aberration, but rather the start of a trend, and it's something we ought to consider as we weigh our investments.

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