The August ISM Manufacturing Survey rose 0.3 to 55.7 exceeding
the trade estimate of 53.8. The data sets a positive tone for the
economic outlook. Digging deeper, the August ISM production index
did ease 2.6 to 62.4, but remains elevated. The production
index has not posted back to back reading above 60.0 since the
February and March 2011.
Production and profits:
The production index shows a strong relationship to the
direction of industrial sector profits. The graphic
following displays the relationship between the ISM production
index (quarterly average) and the year over year growth rate in
industrial sector earnings per share as calculated by
Zacks. The ISM production index tends to lead growth in
industrial sector profits by roughly 2 quarters. The
graphic displays the relationship.
The ISM production index has averaged 60.3 over the past 3
months. The June, July, and August readings are 53.4, 65.0,
and 62.4 respectively. Looking to the end of Q3 2013,
average for the three months to September may get a boost as the
53.4 rolls off the calculation of the average.
The ISM states that a reading in its production index above
51.2 tends to be consistent with an increase in the Federal
Reserve's industrial production index. Given the strong
reading in the ISM production index, industrial production should
record solid growth.
Inventories look supportive to production:
In theory, the production picture is supported by relatively
lean inventories. The customer inventory index in the ISM
fell 5.0 to 42.4 with customer inventories seen too low in 10
industries and too high in just 1 industry. Companies
appear cautious about business activity, and the hand to mouth
psychology could reduce the downside risk to economic growth -
there are few signs of excess. However, the situation in
the Middle East may keep companies in a cautious state and
provide offset to this favorable set up.
A ratio of the ISM inventory index to ISM shipment index has
been falling in recent months. This suggests that the growth in
shipments has been rising faster than the growth in inventories.
This hints that the manufacturing sector is not building excess
and production is low or in line with final demand - a favorable
sign for future output and profitability.
The SPDR Industrial Sector ETF (
) is a direct play on the industrial sector. The sector has
been correcting in line with the S&P 500 since making a high
on August 2
The industrial sector has been ignoring the slowdown in profit
growth up until recently. As industrial profits flattened,
the sector ran higher with the general market helped by the Fed's
QE program and general stock market strength. The
trade has also been expecting a sharp rebound in industrial
sector profits in 2014. According to the Zacks Consensus, 2014
profits for the sector are expected to rise nearly 16.1% compared
to 2013. Bottom line: PE ratio expansion has supported
prices in the industrial sector.
The ratio of the price of the XLI to the Zacks earnings per
share calculation for the industrial sector has risen from 14.6
in the quarter ending June 2012 to an estimated 17.9 for the
quarter ending September 2013. The ratio, a proxy for a
price to earnings ratio, is near the average seen since late 1998
and comfortably below the peaks seen in the last 1990's, 2004 and
2010. A sell off in the industrial sector would open up
some value for the sector.
Given the unease over the events in the Middle East,
uncertainty over U.S. fiscal policy (debt ceiling politics), and
likely QE taper, the industrial sector may be vulnerable to macro
noise which creates an opportunity for those looking for improved
profit growth into 2014.
The weekly chart of the XLI displays signs of support off the
March/April 2013 highs in the $42.00 area and an additional level
of potential support in the $37 area off the 2011 and 2012
The strength in the August ISM production index argues for
improved profit growth in the industrial sector. Those
looking to exploit this budding trend may want to look at the XLI
or stocks in the industrial sector to capitalize on the favorable
set up. Graham Corporation (
) and Gorman Rupp (
) are two Zacks Rank #1 (Strong Buy) companies operating in the
industrial sector and are individual names worth examining.
A correction in the industrial sector linked to macro "noise"
could provide the opportunity for an attractive entry point for
playing a profit recovery in 2014.
GRAHAM CORP (GHM): Free Stock Analysis Report
GORMAN RUPP CO (GRC): Free Stock Analysis
SPDR-INDU SELS (XLI): ETF Research Reports
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