Tuesday, February 9, 2010

Why Do We Look at Manufacturing Surveys Anymore?

Lately the market is dealing with a case of indigestion, with concerns primarily focused on sovereign debt problems in Europe, monetary tightening in China, deteriorating valuation, and the potential for the negative forces of the New Normal to take hold. Recently, a prominent bearish analyst highlighted the Institute for Supply Management’s (ISM) manufacturing and services series, which are leading indices of growth that we routinely follow. His point was essentially that astute investors should be paying attention to the fact that the service sector has been consistently weaker than manufacturing. He went on to imply that since the service component of GDP growth is far bigger than manufacturing, analysts and investors should be paying less attention to the stronger manufacturing numbers, and more attention to services. I take issue with that thought process.

Service-related industries dominate U.S. based GDP, and that fact cannot be disputed. Manufacturing represents less than 12% of the U.S. economy, whereas the service portion is now close to 90%. But despite the large gap between the two, we continue to pay attention to the manufacturing survey due to manufacturing’s sensitivity to the business cycle. In fact, when I read the comments suggesting we should be more focused on the services sector, it immediately brought me back to early 2008, when the same debate was occurring, but in reverse. Back in early 2008, the service data were holding up better than manufacturing, and bullish pundits were howling that the service economy was not showing weakness, and therefore the weaker manufacturing numbers should be ignored. As it turned out, after a somewhat brief lag time, the services numbers eventually weakened in line with manufacturing, and the rest in history.

At Pinnacle we don’t have any issue with following the ISM services data. In fact, we think it’s wise to follow both series as part of a weight of the evidence approach. However, we would be careful about falling into the trap of thinking that just because manufacturing doesn’t represent a large percentage weighting within GDP, that it isn’t a useful leading indicator of the business cycle. Those that chose that faulty line of reasoning back in 2008 were severely punished when services diverged from manufacturing. I see no reason to believe this time will be different.