The Institute for Supply Management’s (ISM) Manufacturing Index for May fell to 59.7 from 60.4 in April, but that was better than the 59.4 level that was expected by the consensus of economists. Any reading above 50 indicates that the manufacturing economy is expanding, and a level near 60 indicates that the manufacturing economy is not just expanding, but booming. This month’s decline thus still indicates a very robust expansion, though at a slightly slower rate than in April.
The overall index is made up of 10 sub-indexes. Eight of those indexes were above the magic 50 level in May (same as in April), but six of them declined in May, while three were up and one, new orders, was unchanged.
The Most Important Sub-Indexes
Of the sub-indexes, the most important measure of current conditions is the index for production. It slipped by 0.3 points, but still remains at an extremely robust 66.6. The most important gauge looking to the immediate future is the sub-index for new orders, which was the one that was unchanged, but at a very high level of 65.7.
With the production index down a bit and new orders unchanged, it is not surprising, then, that the index that tracks the backlog of unfilled orders rose, although the 2.0 point rise was bigger than one would expect. This level is also very healthy at 59.5.
With the employment report due out later this week, jobs are on everyone’s mind, especially with the unemployment rate hovering at 9.9%. The employment sub-index showed the second-largest gain, with a rise of 1.3 points to 59.8. However, the relationship between the ISM employment sub-index and the number of manufacturing jobs reported by the BLS each month has not been as strong recently as it has been historically. The sub-index has been pointing to robust growth in manufacturing employment for several months now (and gains for the last six), but only in the April report did we start to see significant manufacturing job growth.
Sub-Indexes Below 50
The only two sub-indexes that were below the magic 50 level were the two that deal with inventories. They also were responsible for the biggest declines on the month. The index that follows purchasing manager’s assessments of their own inventories declined by 3.8 points to 45.6.
The decline in inventories indicates that we will see less of a boost to GDP growth in the second quarter from inventory restocking. However, production that only serves to pile up goods in warehouses or on retailers shelves is never sustainable for very long.
The sub-index that tracks their assessment of their customers inventories declined another 1.0 point to 32.0, indicating that even more of the purchasing managers think that their customers inventories are too low. If I had to choose two of the indexes to be falling and below the magic 50 mark, it would be those two. When inventories fall too low, they need to be replenished — and that leads to more production (and jobs, revenues and profits) by manufacturers in the future.
An Historical Perspective
Generally, I consider the production, new orders and employment sub-indexes as the most important of the sub-indexes. Their history, along with that of the overall index, since the start of 1980 is shown in the graph below. The graph helps show just how strong the current readings are relative to history.
The overall index has only been above the current level in 5.8% of the months since January 1980. The three key sub-indexes have seen their current readings exceeded even less frequently, 3.0% of the time in the case of the production index (including last month) and 3.6% of the time in the case of the new orders index. As for the employment index, since the start of 1980, it has only been above the current level twice, or 0.5% of the time, in May of 2004 and December of 1983.
The contrast with December of 2008 — when most of the indexes hit their lows for this cycle — is particularly striking. Then the overall index stood at just 32.5, a low that had been exceeded only twice since 1980. The production and new orders indexes were at 25.5 and 22.6, respectively — both record lows — and the employment sub-index was at 29.0, which was lower than all but 1.1% of the months since the start of 1980.
Thus while we did see a decline from April, the decline was coming off an extremely high level. Even the decline, which was less than expected, was mostly driven by the sub-indexes that are concerned with inventories, and having inventories that are too low is not all that much to be concerned about.
Recovery Remains On Track
This was a very positive report and shows that the recovery is on track. The report indicated that 16 of the 18 manufacturing industries tracked were seeing growth, and only one, petroleum products, showed a decline. The best gains were in the paper and wood industries, which would be very good news for the likes of International Paper (IP) and Weyerhaeuser (WY) and in the Transportation Equipment segment, which would include firms like Ford (F), indicating that is rebound is on track.
While Europe might be having trouble, it seems clear that manufacturing side of the U.S. economy is continuing to recover. In recent months, the manufacturing index has been faring better than the non-manufacturing (or service) index, which is due out on Thursday. However, it too has been comfortably above the 50 level for several months now.
The service index does not have the long history that the manufacturing index has, but covers a much bigger part of the overall economy. It is expected to rise to 55.6 from 55.4 in April. For most U.S. firms, an expanding U.S. economy should be more significant than a stagnant one in Europe.
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.
