(LZB) Institute for Supply Management Manufacturing Index Soars

The Institute for Supply Management’s survey of the Manufacturing sector of the economy rose by 3.5 points to 58.4 in January from 54.9 in December. That far exceeded consensus expectations for an increase to 55.5. It is also the highest reading on the consensus index since August of 2004.

This is a stunning turnaround in the index, which in December of 2008 stood at 32.5, its lowest level since March of 1975. The index is set up so that any reading above 50.0 indicates that the manufacturing side of the economy is expanding, and any level below that indicated contraction. It is composed of ten sub-indexes, nine of which rose in January and eight of which are now above the magic 50 mark. The overall index has now been above the 50 mark for six straight months.

Production Levels, New Orders Key

The most important of the sub-indexes for judging the current state of the economy is the one for production — it soared 6.5 points to 66.2, up from an already strong 59.7 in December. This is the highest reading on the production index since April 2004, and dramatically higher than the low for this cycle set back in December 2008 at 25.5.

The rise this month was driven both by a big increase in the number of respondents who said production was up (38% vs. 26%) and by a decline in the number who said things were getting worse (11% vs. 16%). The only industry that was weaker was furniture manufacturing, while 15 industries reported higher production.

If the production index is the most important in telling us about the present, the most important sub-index in telling us about the future in the New Orders index. It rose by 1.1 points to 65.9 from 64.8 in December. Its December 2008 low was 22.9, and this is also the highest reading since April 2004. It was also driven by good news on both sides, an increase in the number of respondents saying things were getting better (41% vs. 35%) and a decline in those saying things were getting worse (16% vs. 19%). Four industries reported lower new orders, while 14 reported increases.

Employment Index Up, As Well

The top focus on most people’s minds right now, though, is jobs. Here, too, the news was good with the employment index rising 3.1 points to 53.3 from 50.2 in December. In February, it had hit an all-time record low of 25.9. The January reading is the highest since April of 2006. In December, the index was just barely positive at 50.2, yet the economy lost 27,000 manufacturing jobs in the month.

We will see on Friday if the stronger ISM employment report actually translates into new manufacturing jobs according to the Bureau of Labor Statistics (BLS). It would be very good news if it does.

The graph below shows the history of the overall PMI and these three key sub-indexes. Unfortunately, the St. Louis Federal Reserve site has not yet updated the numbers for January (this will probably happen later this afternoon or tomorrow) so the data in the graph is only through December, but it does give some context to put the current readings in.

Note that the employment index (blue line) usually stays well below the other lines, especially coming out of recessions. Then again, the economy has been steadily losing manufacturing jobs through both good and bad times for the last 30 years or so.

The improvement in the employment index came mostly from a decline in respondents who said they were cutting jobs (12% vs. 18%); the number of respondents who said that they were increasing jobs actually fell, to 15% from 17%. There was a big increase then in the number of respondents who said they are standing pat on the jobs front.

The employment numbers that will come out on Friday measure the net between jobs lost and jobs created. For some time now it has been apparent that the jobs lost situation is coming under control; however, there is a huge problem with very few jobs being created. Seven industries reported increases in jobs, while six reported declines.

The only two sub-indexes that are below the 50 level are the two which deal with inventories. Much has been made about how the fourth quarter GDP growth was all an inventory bounce.

Well, yes and no on that. Yes, inventory liquidation in the fourth quarter was much less than it was in the third quarter (or the second or the first for that matter). However, in the fourth quarter, inventories were still being liquidated at a $40 billion annual rate. The decline in the rate of inventory liquidation did provide a huge boost to GDP growth, and accounted for 3.39 points of the 5.70 total growth or almost 60% of the total growth.

However, it does not mean that goods are piling up on store shelves. If they were, then the boost from inventories would have been fleeting. We still have destocking going on, and the restocking process has lots of room to run, which means that inventories could be a positive contributor to GDP growth again in the first quarter and even into the second and third quarters of this year.

Inventories In-Depth

The respondents’ assessment of their own inventories supports this, with the inventory index rising to 46.5 from 43.0, an increase of 3.5 points — but note that it is still well below 50. In other words, their inventories are still contracting, but just doing so at a slower rate. While inventory contraction puts a drag on the current economy, it sets it up for future growth as those inventories are replenished.

Their assessment of their customers’ inventory situation was bad on both fronts, at least from the point of view of current growth. Only 4% of the purchasing managers surveyed thought that their customers inventories were too high in January, down from 7% in December. As for inventories being too low, that shot up to 40% from 37% in December.

The overall customers inventories sub-index fell to 32.0 from 35.0% and remains the weakest of the sub-indexes by a very large margin. If I had to chose one of the sub-indexes to be on the low side, this would be the one (or perhaps the other inventory number). No industries reported that their customers had higher inventories, while 13 of the 18 industries tracked reported lower customer inventories.

The increase in the production index did not cut into the backlog of orders that manufacturers have. The backlog sub-index rose 6.0 points to 56.0 from 50.0 in December. This is a very positive sign for the next few months.

Looking Ahead: Service Index

Overall this was a very positive report. However, it only deals with the Manufacturing side of the economy. On Wednesday, the ISM non-manufacturing or Service index is due out. It does not have the long and venerable history that the Manufacturers’ index has, but it covers a much larger part of the economy. In recent months it has been running significantly below that of the manufacturing index.

Still, this is a very strong report showing that manufacturing has lots of momentum so far in 2010. It is also a stunning turnaround from where we stood just a little over a year ago. While we have a long way to go, this report indicates we are clearly headed in the right direction.

In terms of the industries, the furniture industry was consistently noted as being on the weak side of things, which is not a good omen for the likes of La-Z-Boy (LZB) or Ethan Allen (ETH). On the other hand, primary metals and Transportation equipment were consistently mentioned among the industries showing strength. That probably bodes well for firms like Freeport McMoRan (FCX) and Nucor (NUE) as well as firms like Ford (F).

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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