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Why the Philly Fed’s August jump is good for homebuilders

Brent Nyitray, CFA, MBA

The Philadelphia Fed Survey is an important survey about economic expectations in the Mid-Atlantic region

The diffusion index is based on the number of businesses reporting increased activity less the number of businesses reporting decreased activity. It also includes an index of expectations for six months out. The survey drills down into orders and shipments, employment, inventories, and prices. It also includes a special survey that changes each month. In many ways, it’s similar to the New York Fed’s Empire State Manufacturing Survey.

(Read more: Homebuilders breathe a sigh of relief as mortgage rates fall)

Most of these Federal Reserve indices are diffusion indices, which pose the question, “Is this statistic (orders, pricing, or hiring) going up, staying the same, or going down?” The index value is the percentage of respondents who answered “up” minus those who answered “down.” In other words, if respondents are asked whether they expect hiring to increase over the next six months, and 25% say  it will increase, 60% say employment will stay the same, and 15% say employment will decrease, the results make the diffusion index 10 (25% expect employment to rise minus the 15% who expect employment to fall).

The index rebounded in September, building on the strength over the summer

The overall index rose from 9.3 in August to 22.3 in September, the highest reading since early 2011. The most important indicators—general activity, new orders, and shipments—all increased.

The six-month outlook is much better, with 58% of manufacturers anticipating increased activity and 0% anticipating decreased activity. New orders and shipments are the strongest components—31% anticipate an increasing headcount within the next six months, while 6% expect lower employment. Pricing pressures seem to be building, with prices paid and prices received both increasing.

Overall, the index basically showed growth in the Philadelphia Fed region, which includes eastern Philadelphia, Delaware, and southern New Jersey. Despite the current soft patch, the six-month outlook seems much better.

(Read more: Why you should consider the mortgage applications indices)

Implications for homebuilders

Overall, the report shows the economy is still expanding moderately, and that the labor market should start improving. Confidence is still positive, although the outlook for the future is picking up somewhat. Consumer sentiment is driven first and foremost by jobs, and this report indicates that the job picture should improve in the next six months.

Overall increases in consumer sentiment are starting to drive more business for homebuilders, like Lennar (LEN), KB Home (KBH), Toll Brothers (TOL), Standard Pacific (SPF), and NVR (NVR). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves. The shortage of skilled workers could negatively affect margins as business expands. We saw some mention of margin pressures going forward for homebuilders, although virtually every builder reported increased gross margins.

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

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