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Manufacturing is expanding robustly, good for homebuilders

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 means the economy in general is expanding.

ISM PMIEnlarge Graph

Manufacturing activity strengthened in July after rebounding in June

The index of overall activity rose to 55.4 in July from 50.9 in June, indicating expansion for the fifth month out of six. New orders and production drove the increase. Employment rose as well. Inventories, backlog, and prices paid fell.

Investors can use PMI to predict GDP growth. The current level for July (55.4) corresponds to a 4.1% increase in GDP. The average from January to July (52.1) corresponds to a GDP growth rate of 3.1%. The bond market sold off pretty heavily on the number, as it portends the end of quantitative easing.

Implications for homebuilders

Overall, the report shows the economy beginning to pick up steam. While the ISM PMI can be a volatile index and you shouldn’t read too much into the trends, the bottom line is that year-to-date, the index would correspond to a GDP growth rate of 3.1%. It’s important to realize that manufacturing, which is what this index looks at, is no longer as big of a driver of economic growth as it used to be.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Standard Pacific (SPF), Lennar (LEN), KB Homes (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 because 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 the shortage to be a blessing in disguise because 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.