The index of industrial production released monthly by the Federal Reserve provides a complete picture of trends in manufacturing. It is a comprehensive report showing the growth in various sectors of the manufacturing industry. The manufacturing sector is very strong when growth is above .3 or .4 on a monthly basis. Accelerating industrial output is a sign that employment, sales and income are strong and the economy is robust.
A slowdown in the industrial production index is a sign that employment and income will slow down, and sales are weaker. Trends in the industrial production index, as we will see later, is also closely related to trends in overall commodity prices. A strengthening industrial sector is usually associated with firm commodities, and a weakening manufacturing index is accompanied by declining commodities.
Average weekly hours paid per production on a supervisory worker per week is an important indicator of economic activity, especially in manufacturing. The importance of this indicator lies in the fact that when manufacturing wants to reduce output, the first thing they do is cut working hours. Eventually, they will layoff workers. The same thing happens when the economy improves. First, manufacturing expands working hours, and then hires workers. Average weekly hours provides clues on the future of industrial production. Changes in average weekly hours tend to lead changes in economic activity.
Another indicator that provides clues on the future of industrial activity is overtime. Average weekly overtime hours of production is a leading indicator of economic activity because the manufacturing sector tends to cut overtime first, when they see economic activity or demand for goods slowing down. The same thing happens when the economy starts improving. The first action that the businessperson takes is to extend overtime hours before hiring new people. All the above data are available in the industrial production release.
New orders for durable goods and new orders for consumer goods are important data because they provide an indication of what is on the books of manufacturers. Rising orders suggest manufacturing will have to place those orders into production, and that manufacturing will have to step up production activity. If, on the other hand, orders decline or slow down, there are fewer orders to be processed through the manufacturing plants, and industrial output is likely to decline.
When orders are received by an organization, they are not filled right away because the organization or the plant is busy fulfilling previously received orders. Current orders are therefore placed in a backlog and are scheduled to be produced in the future when manufacturing capacity becomes available. For this reason, rising orders are a reliable indicator that the manufacturing sector will improve.
On the other hand, if orders begin to decline, the organization will have to reduce production. For this reason, orders are a very important leading indicator of what will happen to the manufacturing and non-manufacturing sectors. They are an excellent indicator of future economic health.
Orders for durable goods are particularly volatile because big-ticket items are subject to consumer sentiment. The volatility of new orders is caused by the fact that most consumers react at the same time to changes in interest rates and inflation. The reason is that to purchase durable goods - items that have a shelf life of three to four years like automobiles, refrigerators, furniture and so on - people have to commit large sums of money and everybody reacts at the same time and in the same way to changes in interest rates, causing volatility in orders.
When economic conditions change because of rising inflation or interest rates, all consumers will respond to that increase at the same time, and therefore, orders decline sharply. The rise in inflation produces a very important chain reaction in the business and financial cycles. A rise in inflation has a very important effect on income of the working and non-working populations. Rising inflation reduces the purchasing power of consumers and the more inflation rises, the higher is the loss of purchasing power.
The outcome is that consumers defend themselves against the loss of purchasing power by first decreasing purchases of big ticket items and then eventually the small ticket items. The outcome to lower purchases is a decline in orders, and therefore, a slowdown in economic activity.
The increase in inflation is also accompanied by increasing interest rates, and therefore, an increase in borrowing costs. This increase in borrowing costs leads to further declines in purchases on the part of the consumers and investments on the part of business. On the other hand, when inflation and interest rates decline, because of the lower cost of borrowing and increased income caused by lower inflation, consumers are inclined to borrow to purchase those items they found too expensive when inflation and interest rates were rising.
A decline in inflation has exactly the opposite effect of the rise in inflation. A decline in inflation is welcomed by consumers because it increases the purchasing power of the working population. Also, declining inflation is accompanied by lower interest rates. So we have two positive effects on consumer purchasing power. One is lower inflation that increases purchasing power and lower interest rates that decrease the cost of borrowing. Both lead the consumer to purchase and businessmen to invest. The outcome is an increase in orders, which results in the improved growth of the economy. This is the reason why orders provide important information about the future of the economy. Orders for durable goods represent the willingness of business to expand capacity and improve productivity, which is a very important element for economic growth.
Another important indicator concerning manufacturing health and trends is unfilled orders, or the backlogs on the books of the manufacturing sectors. If unfilled orders increase rapidly, manufacturing does not have the capacity to produce goods, and implies manufacturing will be busy filling these unfilled orders. It suggests that the economy will strengthen. If on the other hand unfilled orders decline, manufacturing will be forced to slow down and produce fewer goods. Information about orders is released by the Census.
The National Association of Purchasing Managers provides two important reports: one on the manufacturing sector and one on the non-manufacturing sector. The index provided by this professional group is important because it is an index that oscillates above 50 or below 50. An increase in the index well above 50 implies that the economy is expanding more rapidly. A decline in the index means that the economy is slowing down. If the index falls below 50, the economy is growing very slowly. From an investor viewpoint, this index is very easy to use. It provides simple guidelines to develop an investment strategy. When the index rises above 50, investors have to look for those events that are typically associated with a strong economy growing at an above-average pace. Investors should look for rising interest rates and upward pressure on inflation. We will see later how this could be used to develop an investment strategy.
However, when the index falls below 50, investors are warned that the economy is growing at a below-average pace, and therefore, should expect events that are typically associated with a slower growth in the economy, such as declining interest rates and declining inflation.
An important indicator released by the purchasing managers is called vendor performance. This is an index that shows the percentage of companies reporting slower deliveries. When this indicator rises, more and more companies are reporting slower deliveries, which is an indication the manufacturing sector is very busy and the economy is very strong.
A rise in this index is good news for the economy. A decline in this index is bad news. This index oscillates around 50. If it stays above 50, the economy is strong, and if it goes below 50, the economy is sluggish.
Vendor performance can be used to confirm the trends and the information provided by the overall index of the National Association of Purchasing Managers. Investors using this indicator will be warned that if this gauge rises above 50, the economy is strengthening, growing above potential. Therefore, they should expect rising inflation and interest rates. The higher the indicator goes above 50, the more pronounced the increase in inflation and interest rates is.
hen this gauge falls below 50, the economy slows down and is growing below potential. Investors should expect declining inflation and declining interest rates in the near-term. The more pronounced the decline is below 50, the more pronounced the decline in inflation and interest rates is.
Change in inventories is another important indicator of manufacturing health. Acceleration in inventories indicates manufacturing is building up inventories at a faster and faster pace trying to meet strong sales. A strong inventory accumulation suggests the economy is robust. On the other hand, when inventory growth declines, it signals a slow down in the manufacturing process.
An important gauge used to gain more insight in this process is the inventory-to-sales ratio. The inventory- to-sales ratio is computed at the merchant wholesalers and the manufacturing and trade levels and is computed by the Department of Commerce. The ratio is computed by dividing total inventories in dollar terms by sales over a month. If the inventory-to-sales ratio is low and stable, inventories and sales are in balance and the economy is doing well.
A decline in inventory-to-sales ratio indicates that sales are growing faster than inventories and manufacturing must catch up with sales. This indicates a very strong economy.
However, when the inventory-to-sales ratio is rising, it indicates that manufacturing is building inventories at a rate faster than sales. This situation suggests that manufacturing will have to slow down output to keep inventories in balance with sales. For these reasons, the inventory-to-sales ratio is an important gauge to assess the growth of the economy and to confirm the strengths or weaknesses of business activity.
For instance, in 1993-1994 the inventory-to-sales ratio declined quite sharply from 1.45 to 1.37. The information could have been used to conclude that sales were growing much faster than inventories. Manufacturing was forced to build inventories, and therefore, increase production. Declining inventory-to-sales ratio means that the economy is strong. Usually a similar trend should be found in the unemployment rate, with the unemployment rate declining as employment grows more rapidly than the supply of labor. However, the inventory-to-sales ratio rose sharply in 1995 from 1.37 to 1.45, suggesting the economy was slowing down.
In 1997-98 the manufacturing sector weakened because of the financial crisis in Asia, and because of the weakness in demand, the inventory-to-sales ratio increased from 1.36 to 1.40 over two years. This was an indication that business was slowing down rapidly, sales were slowing down faster than inventories, and therefore, manufacturing was forced to slow down production to match the growth in inventories to the growth in sales. The continued increase in inventory-to-sales ratio indicated a weakening in the economy.
As soon as the financial crisis of Asia normalized in late 1998, business from Asia increased, demand in U.S. increased, the manufacturing sector improved, and the inventory-to-sales ratio declined rapidly indicating that the economy was very strong again. The trend in the inventory-to-sales ratio is a very useful gauge to confirm other information derived from different sources.
Comparing growth in inventories to growth in sales is also a good indicator of the health of the economy. If inventories are growing slowly and sales are growing rapidly, it is clear that the manufacturer will have to increase output to build inventories to match sales. The opposite is also true. If sales are sluggish and inventories are growing rapidly, manufacturers are likely to cut back production to slow down growth of inventories until inventory accumulation matches the rate of growth of sales.
As businesses increase inventories to meet increasing sales, they have to borrow more to finance inventories. During such times, business borrowing increases placing upward pressure on short-term interest rates. When inventories are reduced, businesses will need less money to finance inventory buildup and business borrowing slows down. Slower growth in borrowing places downward pressure on the demand for money and on short–term interest rates. What is suggested is that trends in the price of money, i.e. interest rates, is greatly influenced by its demand. Inventory data are available from the Census.
The above indicators will give you a sense that the manufacturing sector is strong if:
• The index of industrial production is rising above 3-4% a year.
• Average weekly hours are rising, which is positive in the sense that income is increasing, but also negative because it might be an indication that inflation pressures are increasing.
• Rising overtime hours.
• Increases in durable goods orders.
• Increase in backlogs.
• The index of the National Association of Purchasing Managers moving above 50.
• The index of vendor performance moving above 50.
• Inventories accelerating.
• Inventory-to-sales ratio declining.
The manufacturing sector gives signs of weakening when:
• The industrial production index is rising below 3-4% a year.
• The average weekly hours are declining, which is negative in the sense that income is decreasing, but also positive because it might be an indication that inflation pressures are decreasing.
• Declining overtime hours.
• Declining durable goods orders.
• Declining backlogs.
• The index of the National Association of Purchasing Managers moving below 50.
• The index of vendor performance moving below 50.
• Inventories slowing down.
• The inventory-to-sales ratio rises.
(From my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager
Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.
Shouldn't you too subscribe to The Peter Dag Portfolio?
No comments:
Post a Comment