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The August ISM Manufacturing Survey rose 0.3 to 55.7 exceeding the trade estimate of 53.8. The data sets a positive tone for the economic outlook. Digging deeper, the August ISM production index did ease 2.6 to 62.4, but remains elevated.  The production index has not posted back to back reading above 60.0 since the February and March 2011.   

Production and profits:

The production index shows a strong relationship to the direction of industrial sector profits.  The graphic following displays the relationship between the ISM production index (quarterly average) and the year over year growth rate in industrial sector earnings per share as calculated by Zacks.  The ISM production index tends to lead growth in industrial sector profits by roughly 2 quarters.  The graphic displays the relationship. 

The ISM production index has averaged 60.3 over the past 3 months.  The June, July, and August readings are 53.4, 65.0, and 62.4 respectively.  Looking to the end of Q3 2013, average for the three months to September may get a boost as the 53.4 rolls off the calculation of the average.

The ISM states that a reading in its production index above 51.2 tends to be consistent with an increase in the Federal Reserve’s industrial production index.  Given the strong reading in the ISM production index, industrial production should record solid growth.

Inventories look supportive to production:

In theory, the production picture is supported by relatively lean inventories.  The customer inventory index in the ISM fell 5.0 to 42.4 with customer inventories seen too low in 10 industries and too high in just 1 industry.  Companies appear cautious about business activity, and the hand to mouth psychology could reduce the downside risk to economic growth – there are few signs of excess.  However, the situation in the Middle East may keep companies in a cautious state and provide offset to this favorable set up.

A ratio of the ISM inventory index to ISM shipment index has been falling in recent months. This suggests that the growth in shipments has been rising faster than the growth in inventories. This hints that the manufacturing sector is not building excess and production is low or in line with final demand – a favorable sign for future output and profitability.

Market implications:

The SPDR Industrial Sector ETF (XLI - ETF report) is a direct play on the industrial sector.  The sector has been correcting in line with the S&P 500 since making a high on August 2nd.  

The industrial sector has been ignoring the slowdown in profit growth up until recently.  As industrial profits flattened, the sector ran higher with the general market helped by the Fed’s QE program and general stock market strength.   The trade has also been expecting a sharp rebound in industrial sector profits in 2014. According to the Zacks Consensus, 2014 profits for the sector are expected to rise nearly 16.1% compared to 2013.  Bottom line: PE ratio expansion has supported prices in the industrial sector.

The ratio of the price of the XLI to the Zacks earnings per share calculation for the industrial sector has risen from 14.6 in the quarter ending June 2012 to an estimated 17.9 for the quarter ending September 2013.  The ratio, a proxy for a price to earnings ratio, is near the average seen since late 1998 and comfortably below the peaks seen in the last 1990’s, 2004 and 2010.  A sell off in the industrial sector would open up some value for the sector.  

Given the unease over the events in the Middle East, uncertainty over U.S. fiscal policy (debt ceiling politics), and likely QE taper, the industrial sector may be vulnerable to macro noise which creates an opportunity for those looking for improved profit growth into  2014.

The weekly chart of the XLI displays signs of support off the March/April 2013 highs in the $42.00 area and an additional level of potential support in the $37 area off the 2011 and 2012 highs.

Conclusions:

The strength in the August ISM production index argues for improved profit growth in the industrial sector.  Those looking to exploit this budding trend may want to look at the XLI or stocks in the industrial sector to capitalize on the favorable set up.  Graham Corporation (GHM - Snapshot Report) and Gorman Rupp (GRC - Snapshot Report) are two Zacks Rank #1 (Strong Buy) companies operating in the industrial sector and are individual names worth examining.  A correction in the industrial sector linked to macro “noise” could provide the opportunity for an attractive entry point for playing a profit recovery in 2014.

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