ISM Manufacturing Index - December 2009

ISM's Index Spurred Stocks, but the Data Hides Deceptive and Less Than Sustainable Drivers

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ISM Manufacturing Index

The Institute for Supply Management (ISM) reported on the manufacturing sector today, noting December's Index improved to a mark of 55.9, up from 53.6 in November. It was the best check-up since 2006, and the stock market took notice, with the Dow Jones Industrials gaining 1.5% on the day (Diamond Trust NYSE: DIA). Economists had forecast improvement for December, but to a lesser extent (54.8), so the positive surprise gave lift to stocks that needed a reason to rise further in 2010. Still, we temper enthusiasm, as we view several aspects of this positive data either unsustainable or deceptive.

The ISM's December Index stood above 50, the threshold for manufacturing sector expansion, for the fifth month in a row. What's better is that the New Orders Index rocketed up to 65.5 in December, from 60.3 in November. A closer inspection of the data, though, reveals that the improvement in New Orders was greatly due to stabilization rather than increased order levels. The percentage of manufacturers reporting improved New Orders actually slipped to 35% in December, from 36% in November. However, the number of manufacturers reporting deterioration in New Orders fell, while those reporting stabilized orders improved to 46%, from 42% in November. Suddenly this key component to the index's improvement and the stock market's rise is less convincing, isn't it?

The Employment Index lagged, showing employers will be cautious with regard to new hiring. The Employment measure reached 52.0, up from 50.8 in November. Besides, manufacturers still have plenty of capacity left to fill before needing to consider the expansion of production. Still, the Production Index ramped to 61.8, from 59.9.

ISM's Flawed Extrapolation

ISM stated its PMI trends indicate general economic expansion over the last eight months, and good times to come. However, we expect this tune will not ring true for this economic cycle. According to ISM, when the PMI rates above 41.2, it historically indicates a growing overall economy. However, extremely high unemployment this time around, and service sector drag, due to tighter capital constraints across the consumer spectrum, likely means ISM's extrapolation of its PMI Index to cover the overall economy is irrelevant with regard to this cycle.

ISM also stated that if its December PMI of 55.9 is annualized, it corresponds with 4.6% GDP growth. Be careful now readers, because the accelerated rate of expansion we are seeing in December's figure is not sustainable in my view. It represents a return to normal inventory stocking, which is likely driving intensified demand for manufacturers' goods in the short term. Therefore, we believe you cannot extrapolate December's data toward a 2010 GDP forecast for 4.6% growth. That's just foolish. Now if by some miracle GDP were to improve that much this year, it would most likely be due to factors other than those covered by ISM.

Manufacturing customers' inventories showed an increased percentage (37%, over 33% previously) of customers reporting inventories were too low in December. This has been the trend over the past few months, and represents a shift to normal trading patterns, in my view. Manufacturers' inventories contracted at a slower rate in December, which implies improved sales trends, but not necessarily driven by sustainable demand (inventory restocking is likely playing a role).

It looks to us like inventory restocking from deeply understocked levels will serve the purpose of lifting the economy in Q4, and maybe into Q1 as well. Still, be aware that this is a trend seen oftentimes in economic cycle history, and oftentimes it is followed by a second dip into economic contraction once normalized inventory meets still sub par absolute demand. Given still high unemployment and cautious employers, we find no reason to forecast any other consequence for this cycle, and therefore, for 2010.

Editor's Note: This article should interest investors in Ford Motor (NYSE: F), General Electric (NYSE: GE), Boeing (NYSE: BA), United Technologies (NYSE: UTX), 3M (NYSE: MMM), Honeywell (NYSE: HON), Toyota Motors (NYSE: TM), Johnson Controls (NYSE: JCI), Magna Int'l (NYSE: MGA), BorgWarner (NYSE: BWA), TRW Automotive (NYSE: TRW), Federal-Mogul (Nasdaq: FDML), Apple (Nasdaq: AAPL), Microsoft (Nasdaq: MSFT).

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