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Monday, March 17, 2008

Manufacturing - another area of weakness

In a post written over the weekend, I described why I thought the financials sector is now close to a bottom.

What was implied but not fully elaborated on is the idea that different sectors will bottom at different times. This concept is certainly nothing that most investors don't already know. We always see market leadership rotate from one group of stocks to another. The group may be based on market-cap or it may be based on business sector.

The question for investors today is: what sector rotation is taking place at the moment?

If the financials have bottomed, does this mean we should go long financials immediately? The conventional wisdom is that it will be a long hard road for the financials to battle back to a point where they would be worth buying. The issue here is patience. Values are compelling now but there may be a long wait to truly reap the rewards.

For those with a shorter term horizon, perhaps it would be interesting to look in another direction.

Just today we got two reports that indicate manufacturing activity is slowing. If you buy into the idea that the U.S. is now sliding into a recession, it is not a stretch to assume that industrial stocks will decline. The question is, are we closer to the beginning of the decline or closer to the end?

Let's take a look at today's two reports.

Here a couple of quotes from the Federal Reserve announcement:

"Industrial production fell 0.5 percent in February after having increased 0.1 percent in January. Much of the decrease in February resulted from a weather-related drop of 3.7 percent in the output of utilities. In the manufacturing sector, output decreased 0.2 percent in February, and declines were fairly widespread across industries. The output of mines moved up 0.4 percent. At 113.7 percent of its 2002 average, total industrial production was 1.0 percent above its year-earlier level. The capacity utilization rate for total industry in February fell 0.6 percentage point, to 80.9 percent, the lowest rate since November 2005."

"The factory operating rate fell 0.3 percentage point in February, to 79.3 percent, a level 0.5 percentage point below its 1972-2007 average. The production of durable goods moved down 0.4 percent. Large production declines were recorded in wood products, primary metals, motor vehicles and parts, furniture and related products, and miscellaneous products."

All told, production of both non-durables and durable goods declined. In addition, capacity utilization was seen to be slightly less. It can't be said that the wheels are coming off manufacturing but on the other hand the numbers are not particularly encouraging either.

The Federal Reserve Bank of New York released their Empire State Manufacturing Index. It fell to a negative 22.2 in March from a negative 11.7 in February. A number below zero indicates contraction. The report showed somewhat of a mixed picture as new orders edged up slightly but stayed in negative territory. Inventories and shipments both fell further below previous unexpectedly negative values.

As readers may recall, the Philadelphia Fed also had a surprisingly bad read on manufacturing in their report last month. That was followed by a bad number from the Institute for Supply Management whose factory index dropped below 50 and pointed to a more widespread contraction in manufacturing.

After today's market action, one could argue that I might have been premature in determining the financials had bottomed. It appears from the latest batch of reports, however, that industrials are just building up some momentum on the downside.

Many U.S. manufacturers have been benefiting from the weak dollar and bolstering their income statements via strong exports. There is discussion that, with financial and economic problems spreading, other countries may begin to lower their interest rates, making the dollar look stronger in comparison. Overseas demand may also begin to flag if the malaise in the U.S. continues to spread globally.

Are we on the verge of an acceleration in the decline of the manufacturing stocks? Industrials, as represented by the SPDR Industrials ETF (XLI) are off about 16% from their peak in October 2007. XLI, which closed today $35.90, is currently well above the January intraday low of $32.40.

If you believe that the industrials have room to fall further, you may be interested in the ProShares UltraShort Industrials ETF (SIJ). At about $67, SIJ is riding along above its 50-day moving average which at the beginning of this year crossed above its 200-day moving average. The Aroon indicators show the strong up-trend that has been in place may be weakening but the Chaikin Money Flow indicates there is still plenty of buying pressure. The RSI measurement looks like the ETF has a way to go before it could be considered over-bought. This ETF is somewhat thinly traded but it could be the right investment to play a recession-driven slowdown in manufacturing.

Disclosure: author has a small position in SIJ

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