What the Factory Orders Report Tells Us About the Economy

The Factory Orders Report comes out the first of the month and in May it held out hope that the economy was performing better than expected. This report is meant to show the overall health of the entire manufacturing sector, as it measures new orders, inventories, total shipments, and unfilled orders for the month that was surveyed. This latest report shows a decrease in the contraction of the manufacturing sector and reported similar improvement in the Asian and European markets.

The Factory Orders Report shows statistics in current dollars and percent changes from the previous month and the prior year. This indicator is valuable because it shows:

• Supply and demand

• Compares inventory levels to current shipments

• Evaluates the number of new orders

• These are all indicators of consumer demand and its effect upon GDP (gross domestic product).

The Institute for Supply Management (ISM) reported its manufacturing index was just in at 42.8, which is the highest level since September. Compare this to 40.1 in March. This index is made up of indicators including:

• New orders

• Production

• Employment

• Inventories

• Prices

• Export and import orders

ISM said that the May report showed “signs of improvement since last month and the 28 year low of 32.9 in December 2008”. As the index of new orders rose in May to 51.1, up from 47.2 in April, experts cite this as the first month of growth in the new orders index since November 2007. Nine out of eighteen industries reported growth — another good sign. Two things happen when there is an increase in orders from businesses and consumers:

• Manufacturers need to increase production

• As customer inventories fall below 50 for the second straight month, they will need to restock.

The Factory Orders Report is useful for projecting future economic output levels and is used to actually estimate the GDP(gross domestic product) itself. Non-durable manufacturing industries may move as a group when this report is released because of investor activity. The savvy ones who have money in these stocks will have studied data, looking for clues on upcoming earnings levels, and will have reacted aggressively.

The Durable Goods Report examines trends within an industry and it is timely but often a bit vague. This report is not likely to move the broad market because half the data is already known. The ratio of durable to non-durable manufacturing in dollars is about 55/45. Because current dollars are used to estimate values, neither inflation nor price changes affect the methods used to account for inventory. A good example of this is the price of petroleum. For instance, if the price falls in the middle of the month, the company holding the same inventory level based on volume will show a corresponding drop in the value of that inventory. This will in turn be reflected in the value of that company’s petroleum inventory on the Factory Orders Report.

The main benefit of the Factory Orders Report is in its provision of forward-looking data on new business and inventory levels, which may point toward future earning periods. It is valuable for manufacturing firms and investors as they prepare and receive upcoming earnings statements. This is a lagging indicator and usually arrives too late to have any drastic effect on the stock market.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP. Mr. Doran can be reached at (530) 677-1635 or mdoran@sierrainvestor.com.