Tuesday, February 14, 2012

ISM Reports January 2012, With Heteroskedasticity

The recent jobs reports was such good news for the economy and the markets that it overshadowed the good news contained in the ISM reports. My latest ISM 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 revisions in December upward of 0.4%. 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 in Asia, 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 US 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 has shown that every time segments of the economy start heating up, that this is followed by pricing pressures in those sectors. Manufacturing price index jumped 8 points to 55.5%. Slow price increases is a positive sign but this trend in the price index started in October 2011 when the index dropped to 41%. But commodity for 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 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 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 is a portent to positive future reports.

Heteroscedas?? what? (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 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 on the runs that we reject 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 did, but also 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 also correlated with the overall growth of the economy.

Last month our picks resulted in 100% winners on the "Lovers" side as expected if the ISM reports continued 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 below Lovers. Below is a summary of the returns.
(SCSC) ScanSource, Inc 9.2%
(VCI) Valassis Communications, Inc. 21.4 %
(RHT) Red Hat, Inc. 13.75%
(GPOR) Gulfport Energy Corporation 13.25 %
(GCI) Gannett Co., Inc. 1.25%
(LAD) Lithia Motors, Inc. 16.8%
(LNC) Lincoln National Corporation 10%
(SNX) SYNNEX Corporation 9.4%
(HIG) Hartford Financial Services Group, Inc. 8.25%
(AGCO) AGCO Corporation 5.7%
(PRU) Prudential Financial, Inc 10.2%
(HCP) HCP, Inc. 1.5%
(LLTC) Linear Technology Corporation 11.6%
(VRSN) VeriSign, Inc. 4.1%
(CTXS) Citrix Systems, Inc. 5.7%
(SHAW) Shaw Group Inc. 5.8%
(T) AT&T Inc. -0.15%
New Picks based on ISM manufacturing index:
The Lovers and Haters lists are in no particular order but only contain Sabrient rated Strong Buys for the Lovers and Strong Sells for the Haters.

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

Disclaimer: This article is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

Forecast Friday Topic: Heteroscedasticity « Insight Central

MarketWatch Forecast:
ISM Manufacturing: 54.5%
Non-Manufacturing: 53.5%

Misc. Links:

Calculated Risk: ISM Manufacturing index indicates faster expansion in January

The Capital Spectator: Continued Improvement For Manufacturing Activity In January

Vital Signs: Strength in U.S. Manufacturing - Real Time Economics - WSJ

Strong Factory Hiring? Don’t Bet On It - Real Time Economics - WSJ

Calculated Risk: CoreLogic: House Price Index declined 1.4% in December to new post-bubble low

Calculated Risk: Weekly Initial Unemployment Claims decline to 367,000

Econbrowser: Net Exports, Exports, Real Exchange Rates and Manufacturing

The real unemployment rate? — Marginal Revolution

Broader Unemployment Rates, by State - Real Time Economics - WSJ

Calculated Risk: U.S. Light Vehicle Sales at 14.18 million annual rate in January

January Downshift Shouldn’t Be Surprise - Real Time Economics - WSJ

Bring down the rent to boost fairness - The Washington Post

David Smith's EconomicsUK.com: A good start for manufacturing

Vital Signs: Consumer Confidence Inches Down - Real Time Economics - WSJ

The Capital Spectator: ADP: Job Growth Slows In January

The Capital Spectator: Major Asset Classes | Jan 31, 2012 | Performance Update

Human Capital — Marginal Revolution

Vital Signs: Falling Jobless Claims Decline - Real Time Economics - WSJ

Did Economy Really Create 500,000 Jobs? - Real Time Economics - WSJ

Economists React: Jobs Report ‘Positive in Every Way’ - Real Time Economics - WSJ

Good News: Unemployment Falls to 8.3% as U.S. Adds 243,000 Jobs | Business | TIME.com

CARPE DIEM: Highlights from Today's Employment Report

CARPE DIEM: Highlights from Today's Employment Report

The Capital Spectator: Private Payrolls Post A Surprisingly Strong Gain In January

Good News All Around In January Jobs Report

Fantastic news on jobs | Felix Salmon

Calculated Risk: January Employment Report: 243,000 Jobs, 8.3% Unemployment Rate

Economists React: Jobs Report ‘Positive in Every Way’ - Real Time Economics - WSJ

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