The Institute for Supply Management’s (ISM) manufacturing survey slipped to a reading of 56.5 from 58.4 in January, a drop of 1.9 points and below the 58.0 reading that was expected. However, anything over 50 indicates that the manufacturing economy is expanding, so this is still a very strong reading, just less strong than in January. It is also a huge improvement over the rates we were seeing a year ago.

As the graph below shows, the ISM is a good coincident indicator of the economy, plunging during recessions but then recovering quickly as the recession comes to an end. While the ISM index did not set a new post-war record low in this recession the way that several other economic indicators did, it still got down to very scary levels, hitting 32.5 in December of 2008. In addition to the overall ISM index, the history of three most important components are shown (production, new orders and employment).

The overall ISM index is composed of 10 sub-indexes. Eight of those indexes are above the magic 50 dividing line. However, relative to January, five of the indexes dropped. Furthermore, the biggest drops came in the most important of the sub-indexes.

Production Index

The most important gauge of the current state of the economy in the report is the production index, which plunged 7.8 points, but it was at an extremely high level in January, and the decline brought it to a still-high level of 58.4. In other words, manufacturing output was still expanding nicely in February, but not at the very fast pace of January.

New Orders

If the production index tells where we are, the new orders index helps tell where we are going. The story was very much the same — we were at a very high level in January at 65.9, and dropped to 59.5. In absolute terms that is still a very strong reading, but well below the January pace.

Employment

Of particular interest right now is the employment index. This is the third straight month it has been above 50, meaning that we should be seeing a pick up in manufacturing jobs. However, that has yet to show up in the BLS statistics. We will see on Friday if there is was an impact on February.

The 2.8 point gain in the employment index causing a rise to 56.1 is very welcome news. With the growth in production slowing somewhat more than the growth on new orders slowing, the backlog of orders posted a very solid 5.0 point gain to 61.0. This is a good sign for the near future, but says less about conditions a few months out than does the new orders index.

Inventories

The only two of the sub-indexes that are below the 50 level are the ones related to inventories. The responses of firms about their own inventories show that they continue to contract, but are doing so at a slower rate. As we saw from the GDP data on Friday, a slowdown in the pace of inventory liquidation can have a very big impact on overall economic growth. It is, however, a very low quality source of growth.

Still, the good news is that inventories continue contracting (and have been now for 46 straight months, or almost 4 years in a row). This means that we are not seeing a huge build-up of goods on the shelves. Growth caused by the inventory cycle will be transitory, and we will probably see much less of an impact from it in the first quarter numbers. However, it is unlikely that it will actually subtract from growth anytime soon.

The respondents also see their customers inventories as being too low, but much less so than in January, as the index posted a 5.0 point rise. Still, with a reading of 37.0, the customer inventory index is far and away the lowest of all the sub-indexes.   

The Verdict

Overall, this was a moderately disappointing report, but it is far from a disaster. For each of the sub-indexes the ISM lists the industries that are doing well and the ones that are not doing so well. In reading over the report, two industries consistently show up as being weak: wood products and furniture. Given the recent renewed downturn in the housing market, it makes a lot of sense that firms like Weyerhaeuser (WY) would be feeling some of the pain as building new houses is obviously one of the most important uses of wood.

With a slowdown in the rate of both new and used home sales, the furniture industry has lost one of its main drivers. When people move into a new or “new for them” home, they tend to redecorate. Slow home sales means slow sales for firms like La-Z-Boy (LZB) and Ethan Allen (ETH).

Conversely, the Computer and Electronics industries were consistently listed as among the strongest in the various sub-indexes. This probably means good things for the entire tech sector, and is consistent with what we have seen on the earnings front, where the Tech sector had an amazing earnings season — almost all of the firms in the industry exceeded expectations and analysts have been hiking their earnings estimates for 2010 and 2011.

This has been true along the whole Tech chain, from chip makers like Broadcom (BRCM) to component firms like Seagate Technology (STX) to the computer makers themselves such as Hewlett Packard (HPQ), and even to the software firms like Microsoft (MSFT).

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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