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Outlook From ISM Manufacturing Index Declines

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    December 5, 2012

    The recent release of the ISM Manufacturing index continues to point to signs of a slowing economy.   For the most recent month the Purchasing Managers Index (PMI) declined 2.2 percentage points to 49.5 from October’s reading of 51.7.  This reading, which is what is reported by the bulk of the mainstream media, is fairly meaningless.

    From the ISM Report:  “A PMI in excess of 42.6 percent, over a period of time, generallyindicates an expansion of the overall economy. Therefore, the November PMI indicates growth for the 42nd consecutive month in the overall economy, and indicates contraction in the manufacturing sector for the first month following two consecutive months of expansion.

    While the index is still in expansion currently it is the tend of the data that is much more important.  Remember, economic change happens at the margins.  Since the PMI is more of a “sentiment” index (it is a diffusion index that measures positive versus negative sentiment on various areas from employment to production to inventories) it is a better used as a gauge about what businesses will likely do in the future based on their current assessment of conditions.

    The chart below shows the PMI as compared to the 6-month average.


    Clearly the outlook for the economy has been deteriorating over the last few months and the six-month average now resides at the lowest level since October, 2009.   Furthermore, sentiment from respondents has likewise deteriorated as well:

    • “Conditions still appear to be positive for continued growth in sales.” (Machinery)
    • “Business is steady, but not much more than that. We are in a lull.”(Food, Beverage & Tobacco Products)
    • “The principle business conditions that will affect the company over the next three or four quarters will be the U.S. federal government tax and budgetary policies; the impact of those policies is not yet clear.” (Petroleum & Coal Products)
    • “Differences between first half of year and remaining half are very dramatic, growing to a peak in the middle of the year with a gradual decline since.” (Plastics & Rubber Products)
    • Seeing a slowdown in request for quote activity.” (Computer & Electronic Products)
    • “The fiscal cliff is the big worry right now. We will not look toward any type of expansion until this is addressed; if the program that is put in place is more taxes and big spending cuts — which will push us toward recession — forget it.” (Fabricated Metal Products)
    • Seeing a slowdown in demand across markets.” (Electrical Equipment, Appliances & Components)
    • “Economy is very sluggish. Production is down and orders have slowed considerably from Q1.” (Transportation Equipment)
    • East Coast storms delayed some shipments.” (Primary Metals)
    • “Global economic uncertainty still seems to be sticking around which is not necessarily making things worse, but it is also not making things better from a demand standpoint.” (Chemical Products)

    The importance of the change in sentiment is lost on most economists who have never actually owned a business.  However, it is clear that the fiscal cliff, the recent storm, and the continuing Eurozone saga are continuing to erode business sentiment.  This erosion in sentiment in turn affects economically sensitive actions such as production, employment and investment.

    (Note:  I personally own several businesses with one of them specifically in manufacturing for the energy sector.  We have currently ceased all employment plans, have cut back capex to only replacement needs, and are storing cash in anticipation of slower demand in the next 12 months.)

    Breaking the PMI down into its sub-categories we can see the deterioration in sentiment over the last 3 reporting periods.


    New Orders plunged in November likely reflecting the impact of the Hurricane.  However, exports, which are now a major contributor to the overall economy and corporate profits, have been trending weaker as the recession in the Eurozone continues to drag on.  As demand has declined, and order backlogs have been reduced, the sentiment towards increasing employment has plunged.

    On a positive note – inventories have been worked down while supplier deliveries picked up somewhat.  Therefore, if Washington can clean up their act and resolve the “fiscal cliff,” and debt ceiling, debates there could be a economic boost from a restocking of inventories in the short term.

    Recession Warning?

    As a business sentiment indicator the PMI index gives us some insight into what manufacturers across the country think.  However, as an economic indicator by itself, it can be somewhat misleading due to weighting issues, etc.  Therefore, I include the ISM PMI in a composite of other manufacturing related indexes to achieve a broader view of the economic data and trends.  The chart below is the Economic Composite Index which not only uses the ISM PMI but also the Chicago Fed National Activity Index, the NFIB small business survey, several Fed manufacturing indexes and the Chicago PMI.


    As of November there are still a couple of the components, the CFNAI and NFIB, which have not reported as of yet.  However, if we assume that they do not deteriorate any further, the composite index would currently stand at 26.82, down .92 points from last month.  Historically, a reading of this level on the composite index has indicated that the economy was in, or was about to be in, a recession.  The only caveat was in 2011 as the economy slowed due to the debt ceiling debate and manufacturing shutdown due to the Japanese earthquake.  However, that slowdown was offset by a convergence plunging energy prices, global artificial stimulus and the warmest winter in the last 65 years.  Those events that provided a short term boost to the economy at that time are unlikely to repeat currently.

    Are we in a recession now?  The answer is “no” but evidence continues to mount.  In all likelihood we will not know for certain until after the fact as we must wait for the economic data to be revised in the months ahead.  Regardless, the trend of the data is clearly weakening at a rate which most likely puts the economy at risk within the next year.  More importantly, it is the impact of slower economic growth on corporate earnings, and outlooks, which should be of the greatest concern to investors as that is what truly drives returns.

    With any “deal” on the fiscal cliff, and upcoming debt ceiling debate, leading to increased taxes, and reduced government spending, the headwind towards economic growth will continue to increase.  So, while we are not currently in a recession – the market will react to the expectations of the event well before the media acknowledges it.  Complacency is a dangerous thing when it comes to investment portfolios.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of Streettalk Live

    lance robertsAfter having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.