A Macro View: Stock Picking Based On ISM Manufacturing Index, January 2012

The recent jobs reports was so well-received by the economy and the markets that it overshadowed the good news contained in the ISM reports. My latest article on the ISM reports was lukewarm at best, but this month has more silver linings. The biggest upside surprises occurred in the non-manufacturing index where the headline index jumped up 3.8% to 56.8% beating the consensus of 53.3-53.5% and the consensus range of 52-54%. This was even after a 0.4% revision upward in December. The manufacturing headline also bumped up one percent to 54.1% but after a revision down last month of 0.8%. Econoday succinctly stated a summary of the market reactions to the report.

The manufacturing sector is a bulwark of the economy, and, despite troubles in Europe and slowing growth in Asia, it continues to expand, underscored by a faster rate of expansion for new export orders which rose 2 points to 55.0. Despite the strength in orders, there’s little initial reaction to today’s report.

The chart above comes from the WSJ at World-Wide Factory Activity. From that sample of countries, it shows that the U.S. is leading the world in economic development. We may be the first to recover from the great recession while other countries are facing their own set of economic problems.

Prices and Employment

Price pressures have receded in recent months, but there are concerns about prices going forward. Prior experiences in this economic cycle have shown that every time segments of the economy start heating up, pricing pressures in those sectors are soon to follow. The manufacturing price index jumped 8 points to 55.5%. Slow price increases are a positive sign, but this trend in the price index started in October 2011 when the index dropped to 41%.

Commodities used in manufacturing show no signs of causing problems in the near future. Commodity prices in non-manufacturing also showed no signs of increasing for the near future, but the price index increased 1.5% to 63.5% indicating price and cost pressures going forward. On a sector wide basis, this pricing pressure is wide, as 13 sectors reported increases in prices and only 3 reporting decreases with 31% reporting higher prices and only 5% reporting lower prices.

During the “Great Recession” the manufacturing sectors have led the employment index. But unfortunately, most job creation strength is in the “services” sectors. But that situation may have changed last month. The chart above shows the dramatic increase in the non-manufacturing index last month and the trends in the index since December 2009. A few months ago, I lamented that the upward trend line had decayed, but hopefully, this recent report is a portent to future strength in the non-manufacturing sectors. Obama should be pleased. Even if this jump is a fluke, reversion to the mean will continue to indicate employment strength in the mid-50s range.

It is also worth noting that the new export orders increased for both indexes to the acceptable mid-50s range with manufacturing increasing 2% to 55% and non-manufacturing increasing 5.5% to 56.5%. New orders index also showed continued strength with manufacturing increasing 2.8% to 57.6% and non-manufacturing increasing 3.6% to 59.5%. Both indexes, and especially new orders, point to positive future reports.

Wonkish-stock picks below.

Last month, I introduced a simple regression model based on the ISM manufacturing index changes. This month’s regression results will be based on changing the model in two important ways.

The first is to try to correct for any presence of heteroscedasticity in the model runs. Technically that is too much variance in the error terms and thus the model does not reflect minimum variance. Or another way of looking at it is that expecting values become unstable. If you were expecting returns of 5-6%, but next year, the expected returns changes to 1-11%. While the results might not be biased, they become less reliable for predicting the future from the sample even if the sample size is very large. The problem may not be as significant in time series data like stock returns and manufacturing indexes, but the reduction of heteroscedasticity should increase the reliability of the model over the long term.

The model now checks for heteroscedasticity and then tries to correct those runs that failed the test for no heteroscedasticity. Preliminary runs resulted in slightly improved performance for the Lovers group.

The second tweak to the model was incorporating a factor into the model that indicates the level of the headline index. It is not so much the change in direction of the index (i.e. going up or down) as the last model focused on, but whether the index is above or below the 50% mark. This is the dividing line between expansion or slowing of the sector (manufacturing) of the economy, and it is also correlated with the overall growth of the economy.

Last month our picks resulted in 100% winners on the “Lovers” side, as expected (we assumed the ISM reports would continue to be positive). Considering that the broader market (S&P up over 4%) also increased during that time, it was not unexpected. This also drove most of the “Haters” to positive returns but those returns did not overshadow the gains of the Lovers. Below is a summary of the returns.

Lovers:

ScanSource, Inc (SCSC) 9.2%

Valassis Communications, Inc.(VCI) 21.4 %

Red Hat, Inc. (RHT) 13.75%

Gulfport Energy Corporation (GPOR) 13.25 %

Gannett Co., Inc. (GCI) 1.25%

Lithia Motors, Inc. (LAD)16.8%

Lincoln National Corporation (LNC) 10%

SYNNEX Corporation (SNX) 9.4%

Hartford Financial Services Group, Inc. (HIG) 8.25%

AGCO Corporation (AGCO) 5.7%

(PRU) Prudential Financial, Inc 10.2%

Haters:

HCP, Inc. (HCP) 1.5%

Linear Technology Corporation (LLTC) 11.6%

VeriSign, Inc. (VRSN) 4.1%

Citrix Systems, Inc. (CTXS) 5.7%

Shaw Group Inc. (SHAW) 5.8%

AT&T Inc.(T) -0.15%

New Picks based on ISM manufacturing index:

Lovers:

Lithia Motors, Inc

Lincoln National Corporation

Group 1 Automotive, Inc. (GPI)

Standard Motor Products, Inc. (SMP)

Ford Motor Co (F)

Hartford Financial Services Group

Unum Group (UNM)

Allegheny Technologies Incorporated (ATI)

ScanSource, Inc., incorporated

Aflac Incorporated (AFL)

Webster Financial Corporation (WBS)

StanCorp Financial Group, Inc. (SFG)

Haters:

Juniper Networks, Inc. (JNPR)

MicroStrategy Incorporated (MSTR)

MetroPCS Communications, Inc. (PCS)

The Lovers and Haters lists are in no particular order but only contain Sabrient StrongBuys for the Lovers and StrongSells for the Haters.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

SDI Glossary: "Commodities" Definition
SDI Glossary: "price" Definition
SDI Glossary: "Recession" Definition

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