Manufacturing rebound continues, good for homebuilders

Market Realist

The Institute for Supply Management Index assesses the state of manufacturing in the United States

The Institute for Supply Management Purchasing Manager’s Index (ISM PMI for short) is similar to the other regional PMI indices, but it covers the entire country. The ISM PMI looks at various business indices, like new orders, production, employment, supplier deliveries, inventory, customer inventories, prices, backlog, exports and imports, and capital expenditures. A reading over 50 means that manufacturing is generally expanding. A reading over 42 indicates the economy in general is expanding.

(Read more: Bernanke’s comments send mortgage rates screaming higher)

Manufacturing activity has been generally improving all year, with just one sequester-driven contraction in May

The index of overall activity rose to 55.7 in August, indicating expansion for the eighth month out of nine. New orders and production drove the increase. Employment fell. Prices rose as raw material prices increased. Employment registered 53.3—a slow expansionary number.

You can use PMI to predict GDP growth. The current level for August (55.7) would correspond to a 4.2% increase in GDP. The average from January to August (52.5) would correspond to a GDP growth rate of 3.2%. This may explain why the Fed believes employment numbers are going to get better, which is why they’re concentrating on tapering quantitative easing.

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Implications for homebuilders

Manufacturing activity is a good sign for job growth, which has been the Achilles’ heel of this recovery. Although manufacturing isn’t the driver of the economy that it used to be, it still matters. Having a level of manufacturing that corresponds to 3.2% GDP growth is certainly a positive.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Standard Pacific (SPF), Lennar (LEN), KB Home (KBH), Meritage (MTH), and Ryland (RYL). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves. This can create a virtuous circle in the economy, as increasing demand raises prices, which re-ignites the wealth effect and increases consumption. The secular (long-term) story for homebuilders is optimistic. Household formation numbers will be a real wind at their backs.

On the other hand, the shortage of skilled workers could negatively affect margins as business expands. Lennar mentioned this concern on its second quarter conference call, although it considered it to be a blessing in disguise, as higher employment and higher wages will drive consumer confidence and growth. That said, the report noted that raw material prices are increasing, but homebuilders still reported pricing power and margin expansion. An uptick in raw material pricing or labor costs could negatively affect homebuilders, but so far, margins are generally strong.

(Read more: Mortgage rates fall slightly)

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