Healthy Skepticism of ISM Manufacturing Strength

Monday’s reported improvement in the ISM Manufacturing Index confounded the popular wisdom of the day, which sees manufacturing on the downslide. The critically important data point offered a message that seemed to counter many other manufacturing and related data points, including last week’s Durable Goods Orders data. It also countered the negative tone still emanating from the Philadelphia and New York Fed regions, but truth be told, data from Chicago and other Fed regions had hinted at stabilization. Still, I think there may be a fly in the ointment not yet noticed, and that is the impact of higher pricing on the overall PMI and on New Orders. Because the index is created through survey of purchasing managers, who are bottom line oriented, I believe higher prices paid are being passed through to end product and presenting an improved image in the clouded minds of managers.

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It’s also important for investors to remember that this is one month’s data which counters the trend of the prior three months; it also reflects gains over those downtrodden periods (softened base). Finally, the global macroeconomic environment is still slowing in Asia and deteriorating further in Europe. With today’s interdependence of economies, it would be naïve to assume foreign havoc cannot do more damage here at home, where we remain underemployed and where price matters most among consumer decision factors.

My perspective of the current state of the economy is one of issue, and of higher forward concern. Make no mistake about it, the fiscal cliff issue and election uncertainty will put a hold on business activity over the next month or three. Also, war with Iran is highly likely over the next 1 to 6 months, in my view, and should be factored into economic and investment scenarios. I believe it is negligent to completely ignore the issue at this point.

The Manufacturing ISM Report on Business showed its Purchasing Managers Index improved by 1.9 points, enough to take it above 50.0, to a mark of 51.5. The news had the SDPR S&P 500 (NYSE: SPY) up more than half of a percentage point through midday. The SDPR Dow Jones Industrial Average (NYSE: DIA), whose components would seem to be better represented by this data, was up nearly a full point. The Industrial Select Sector SPDR (NYSE: XLI), which is definitely represented by the data, was up to a lesser extent, by 0.6%, which I believe is quite telling. See today’s market report for more on this.

The ISM data showed its New Orders Index, a forward looking measure of interest, moved up by a sharp 5.2 points to 52.3, and into expansionary territory. The Production Index improved as well, rising 2.3 points, though it remained in contraction territory at 49.5. We might say the production index is less reliant on prices, where the orders index can be measured by dollars or units, but is likely thought of in dollar terms by managers. Purchasing managers indicated a renewed propensity to hire, with the Employment Index up 3.1 points to 54.7.

Despite the above listed improvements, there was more than enough reason provided by the report to temper enthusiasm on manufacturing and the economy. Leaving the most important factor for last, we noted Customer Inventories only improved slightly by a half point, and stuck in territory reflecting contraction, at 49.5. Also, Order Backlogs were deeply mired in the mud at 44.0 (+1.5). The Export environment remained difficult as the index improved by 1.5 points to just 48.5. Imports edged up only 0.5 points to a still insufficient 49.5 mark.

Finally, a key factor that could have played an important role in the rise in both new orders and in the overall PMI, may reveal a misleading index. A great many more purchasing managers reported increases in prices paid in September. The Prices Index rose by 4 points to 58.0, which indicates a faster rate of price increase in September than in August. If you survey industrial commodities, you find that some industrial metals declined in price, which reflects poorly for goods demand. Meanwhile, prices for important food components, gasoline, and packaging materials rose, which weigh on manufacturers, increased. Of the 18 manufacturing industries, 10 reported paying increased prices during the month of September in the following order: Food, Beverage & Tobacco Products; Plastics & Rubber Products; Printing & Related Support Activities; Wood Products; Chemical Products; Primary Metals; Furniture & Related Products; Machinery; Fabricated Metal Products; and Miscellaneous Manufacturing.

The indexes are based on survey, and purchasing managers are bottom line driven. They want to meet budgets, and they are of course acutely aware of sales activity in dollar terms. In my view, the increase in prices paid is probably being passed through to some extent, and is directly inflating the new orders and overall PMI data found here. Also, I believe they are indirectly affecting the employment perspective of managers. The other data reported, which was not as dramatically improved, seems to offer a different message.

I suspect the tempered enthusiasm of the XLI offers a check on the gains of the broader indexes today. Investors in this sector will not soon forget the warnings of major players, including Caterpillar’s (NYSE: CAT) of just a week ago. It’s noteworthy that after an early lift, Caterpillar’s shares are lower nearing the close of trading. Though, the shares of most other major industrials are still celebrating the data. This is because capital will not find the sector representative which reported issues. Rather, it will drive in a hopeful manner into the stocks of others, many of which I believe will also eventually report issues.

Company & Ticker	Monday’s Change 2:30 PM
GE (NYSE: GE)	+0.8%
Ford (NYSE: F)	+0.8%
FedEx (NYSE: FDX)	+0.5%
Boeing (NYSE: BA)	+0.8%

It’s my view that this celebration will be short-lived because it is disproportionate to the improvement of September over August and being misled by the price factor. A realistic view of the state of the economy and manufacturing should offer only tempered support to the manufacturing segment. Investors should be skeptical of this data and its staying power given all other information.

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