What Is The BullWhip Effect That Michael Burry Mentioned?

BullWhip Effect Michael Burry: The first two months of 2020 suggested it would be another strong year for the US stock market. The economy was growing steadily, inflation was at a comfortable 2.3 percent, and most companies were ready to settle in for another successful year.

The pandemic upended everyone’s plans. The market crashed, and the global economy ground to a halt. Incomes plummeted, and consumers stopped spending money. They focused on necessities – and even then, they limited purchases to those items that could be delivered to their homes or picked up outside stores.

The government took quick action to keep the economy afloat. Interest rates dropped and massive aid packages injected cash into the economy. The plan worked – perhaps a little too well. At the end of 2021 and into 2022, inflation reached heights that haven’t been seen since the 1980s.

In response, the Federal Reserve started bringing interest rates back up, beginning with a 0.25 percent increase in March 2022, a 0.50 percent increase in May 2022, and a 0.75 percent increase in June 2022.

More rate hikes are expected in the coming months. However, Michael Burry, the investor immortalized in the 2015 Hollywood film The Big Short for predicting the subprime mortgage crisis, isn’t so sure that the Fed will be able to stay the course.

Burry is confident that a phenomenon called the BullWhip Effect will curb inflation naturally, putting the Fed in the awkward position of reversing its strategy. In a recent Twitter post, he suggested that due to the BullWhip Effect, plans for additional interest rate hikes could be scrapped. There is even a possibility that rates could drop again.

What Is The BullWhip Effect?

The BullWhip effect is named after the movement of a bullwhip, because a small flick of the wrist at one end of the whip creates a series of growing waves throughout the length of the material. By the time the motion reaches the end of the whip, it is moving in large waves that appear out of proportion to the original amount of force used.

The same thing happens with the supply chain. When customers select products from store shelves, they are the final link in a long chain of events. Retailers purchase the products they sell from distributors, who buy them from manufacturers. Manufacturers, in turn, must procure raw materials, packaging, and other components from a variety of sources.

There are dozens of stakeholders involved in the process from start to finish, and the entire system depends on a delicate balance of supply and demand. Retailers don’t want warehouses full of unsold inventory, and neither do distributors. However, they also want to keep shelves fully stocked. All rely on their own experience, coupled with sophisticated technology, to predict consumer demand.

The BullWhip Effect refers to a situation in which small changes in demand at the point of sale have a ripple effect. The changes in demand cause distributors to make adjustments to their orders. That prompts manufacturers to alter production rates and so on down the line. At every stop, the effect is amplified far beyond the original shift in consumer demand.

Example of BullWhip Effect

Grocery stores are particularly sensitive to changes in consumer demand because many foods are perishable. Even those with a long shelf life expire eventually, creating waste. That’s a problem when margins are already slim. Consider this example of the BullWhip Effect:

Over a typical week, consumers purchase ten cases of fruit punch from a particular store. The distributor ensures that ten cases are ordered for that location each week to prevent lost sales due to empty shelves.

Then, unexpectedly, consumers purchase the ten cases faster than expected, and the store runs out of fruit punch before a new delivery arrives. In an effort to keep up with consumer demand, the distributor orders 12 cases the following week.

The manufacturer notes this change and wants to avoid backorders, so production increases to 15 cases. All of the companies that contribute materials for the manufacturing process increase their production as well, adding a margin of safety with a little extra to make sure their client, the manufacturer, is happy. By the end of the chain, there are enough materials for 20 cases of fruit punch.

Meanwhile, back at the market, the run on fruit punch is over. Whatever prompted consumers to stock up on that particular product has ended, and the store goes back to selling ten cases per week. The stockroom starts to fill up, and the market doesn’t have space for all the unsold fruit punch. The product is marked down for faster sale, and consumers see lower prices for the same beverage.

What Causes The BullWhip Effect?

Holding a lot of inventory is expensive for retailers, so most have shifted to a just-in-time system. However, the success of a just-in-time system relies on perfect forecasting. Retailers must be able to project consumer demand well in advance to place orders accurately and account for all of the steps that must occur to get products on shelves.

Even the most experienced retailers and the most sophisticated technology can’t be right all the time, especially when an unexpected event occurs. For example, extreme weather can change shopping behavior, as evidenced by the shortage of milk, bread, and toilet paper every time a storm is predicted.

That explains why stores can be over- or under-stocked, but not why the issue is amplified down the supply chain. The BullWhip Effect – the exponential increase through each link in the chain – is caused by ineffective communication.

Retailers might know exactly why fruit punch is in high demand and how long the increased demand will last. They are familiar with their community and their customers. But that message isn’t passed along to distributors and other stakeholders, so the rest of the supply chain reacts based on limited information.

Other factors that cause poor demand predictions include an overreliance on historical data rather than considering current and upcoming factors that could influence purchase decisions. The introduction of e-commerce, increased delivery and curbside pickup options, and sales or discounts can also impact demand for a certain product. If players fail to communicate with other stakeholders on the chain at any point, forecasting is sure to be wrong.

Pros and Cons of BullWhip Effect

The BullWhip Effect isn’t all bad from a consumer perspective, depending on whether there is an oversupply or undersupply of the goods in question. An oversupply typically prompts a reduction in prices until the excess inventory is depleted.

In the current environment, there isn’t just one product involved. The rates of inflation inspired many retailers to ramp up their ordering, and now most are awash in unsold goods. Michael Burry indicated this could cause a mass price reduction, naturally bringing inflation into check. If inflation goes down too much, the Fed may have to toss plans for additional interest rate hikes to ensure relative stability in pricing.

There are four ways the BullWhip Effect impacts the supply chain, and they are generally undesirable. An oversupply of products is expensive, and there are no good choices to dispose of the excess items. The product must be sold at deep discounts – perhaps at a loss – or stored, which incurs another set of costs.

An undersupply of products is not much better. Lead time is compressed, which creates strain on workers, facilities, and equipment, and an inability to get products delivered on time means a poor customer experience. If customers are disappointed often, they may choose to end the business relationship and move on to other suppliers, distributors, and retailers.

How To Reduce The BullWhip Effect

The most effective method of reducing the BullWhip Effect comes down to improved communication and collaboration among stakeholders. When suppliers, distributors, and retailers keep each other apprised of changes in the business, forecasting improves up and down the line.

Investing in the most advanced forecasting and visibility tools can also reduce instances of the BullWhip Effect. While the output from such tools is only as good as the information coming in, the software is adept at identifying and acting on patterns that aren’t visible to human analysts.

Will the BullWhip Effect succeed in reducing inflation this year? Michael Burry thinks so. If he is correct, it will again prove his unique talent for accurately predicting the market’s future.

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