Why the Philly Fed Index hit a 3-year high, showing strong growth

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.

Why the Philly Fed Index hit a 3-year high, showing strong growth

Most of these Federal Reserve indices are diffusion indices that 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. That is, 25% would expect employment to rise minus the 15% who would expect employment to fall.

The index holds at high teens levels

The overall index rose from 17.8 in June to 23.9 in June. This is the highest reading since 2011. It’s important to emphasize that even though the rate of increase fell from that torrid pace, the index is still increasing and is reasonably high compared to the rest of 2013. New orders and shipments rose substantially. Prices paid were flat, while prices received rose 2.7 points to 16.9.  The six-month outlook increased from 52 to 58.

The index basically showed strong growth in the Philadelphia Fed region. This area includes eastern Philadelphia, Delaware, and southern New Jersey. This report seems to corroborate the idea of a general expansion in manufacturing, which is an important component of economic growth.

Implications for homebuilders

Homebuilders have been uniformly reporting record or close-to-record gross margins, as they’ve been able to raise prices at will. Skilled construction labor is becoming scarce and expensive. Building material prices are rising.

We’ve been seeing traffic decline in the West Coast, where buyers are balking at the high prices. This is a recipe for lower gross margins going forward from builders like Lennar (LEN), D.R. Horton (DHI), PulteGroup (PHM), and Toll Brothers (TOL).

If the builders are unable to raise prices to drive the top line, they’ll begin to have to increase volume to drive the top line. This will go a long way toward improving the economy and the housing market. Investors who are interested in trading the homebuilding sector as a whole should look at the S&P Homebuilder ETF (XHB).