ISM Service Survey Weak - Analyst Blog

The Institute for Supply Management (ISM) reported its survey of non-manufacturing (services) businesses, which showed a decline of 1.8 points in November. This brought the reading down to 48.7, which is significant since it is now again below the 50 reading that marks the border between expansion and contraction.

While the Service index has a much shorter history than the companion Manufacturing survey — and thus there is less of a benchmark to evaluate it, particularly during recessions — it covers a much larger part of the economy. In November, the size of the decline was roughly equal between the manufacturing side (2.1 points) and the 1.8 point decline on the service side, but the absolute level of the manufacturing side was higher at 53.6, showing expansion, though at a slower rate than in October.

The overall index is made up of 10 sub-indexes, nine of which correspond to sub-indexes on the manufacturing side. For gauging the current state of the economy, the most significant of these is the gauge of current production. Both sides of the economy saw a decline in November, but on the service side, activity is actually contracting with a reading of 49.6, down from 55.2 in October. The manufacturing-side growth is still robust, with a reading of 59.9, just a little less robust than the very strong 63.3 reading last month.

Looking ahead, the most important of the indicators is New Orders. There, both sides are seeing an expansion, although for the service side, the rate of expansion slowed, with the sub-index falling to 55.1 from 55.6, while the manufacturing sub-index was not only higher at 60.5, it actually showed an acceleration from 58.5 last month.

The other sub-index of particular concern is the one for employment levels. There the contrast is stark, with expansion seen on the manufacturing side with a reading of 50.8 (although down from 53.1 last month), while on the service side there was a little bit of improvement, but the level was still very low at 41.6 vs. 41.1 last month.

Thus, according to the ISM numbers we should be seeing a pick up in manufacturing employment, and a fall in service jobs. However that was not confirmed, at least with respect to manufacturing by the employment report from the BLS last month, nor by the ADP numbers released yesterday.

We will see tomorrow what the BLS has to say on the subject for November. Since there are roughly six times as many people working in the service side of the economy, the service reading is obviously far more important.

One area where both parts of the economy are showing sharp contractions is in inventories. Generally speaking, though, inventories tend to be much more important to manufacturing companies like Ford (F) or Caterpillar (CAT) than they are for many service companies where inventories really just amount to the paper clips in the office supply cabinet.

However, that is not always the case. The retailers are included on the service side, and the level of inventories is a very big deal for the likes of Wal-Mart (WMT) and Target (TGT). Then again, the low inventories will probably be the salvation of many retailers this year in the face of a second straight year of dismal holiday sales. With inventories low, they will not have to be overly promotional, and will have fewer markdowns come January. It also greatly increases their asset turnover, and with it their return on equity (the old DuPont formula of net margin X asset turnover x leverage = ROE).

The table below further contrasts the service and the manufacturing reports and comes from the ISM report itself. Overall, this was a weak report and one to put in the negative column. However, while it is disappointing to see the index fall back below 50 after two months in a row above the “magic” mark, we are still in much better shape than back in December 2008 when the service side was all the way down at 40.1 — so a little bit of perspective is in order.