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Durable Goods Data Still Consistent with Factory Upswing

This morning’s monthly report on durable goods from the Commerce Department showed a 2.5% decline
in new orders in June. Nonetheless, we – and we suspect at least a few other analysts – found the
report broadly positive, based on movements in specific components of the report.

Durable goods orders are potentially an important leading indicator of activity in the manufacturing sector
of the economy, yet they are highly volatile. The standard deviation of the monthly change in durable
goods orders is 3.7%, compared to an average annual growth in the series of a bit less than 2%. The
correlation of sequential month-to-month changes is -0.38, i.e. if orders are up in one month, they are
significantly more likely to be down the next month, and vice versa. So discerning a signal among the
noise is nearly impossible if one focuses only on month-to-month changes in the headline index. We take
three basic approaches to doing so:

1. Using longer time periods. Instead of looking at month-to-month changes, we can look at changes
over three months, six months, or a year. However, for all but the most extreme cycles, it takes six
months or more to pick up a clear pattern in the data – far too long for investors focused on short-term
business cycle fluctuations, or for that matter policymakers attempting to gauge the current state of the
economy. In essence, taking into account too much historical information makes the report a lagging
rather than leading indicator. So, while we look at year-over-year figures when we evaluate the durable
goods release – currently, new orders are down 25% year-over-year, the worst decline on record since
the series began – we do not focus on them in our analysis of where the manufacturing sector and overall
economy are likely to go in the future.

2. Excluding the most volatile components. Another way to look at the numbers is to simply to leave
out the noisiest parts of the report. The two most volatile industry segments, by far, are new nondefense
aircraft and parts (standard deviation of monthly change: 147%) and defense-related orders (standard
deviation of monthly change in defense capital goods orders: 80%). We often cite the monthly figure on
“nondefense capital goods orders ex-aircraft”—up 1.4% in June and over 8% annualized over the past
three months—precisely because it excludes these two very volatile components. We refer to this
grouping as “core capital goods orders”; it is only marginally less volatile, because it also excludes other
more stable categories that do not qualify as capital goods. Nonetheless, there is an additional rationale
for excluding defense and aircraft orders: both of these categories tend to be extremely “lumpy” orders
with very long lead times between the receipt of a new order and the shipment of a product.
Consequently, the month-to-month change in orders in these categories is less relevant for the near-term
economic cycle. The exception to this statement would be if the change in orders is so robust that it
prompts a major investment, for example in new manufacturing facilities.

3. Calculating key ratios. Although headline orders and many other parts of the report are quite volatile
from one month to the next, ratios between them may be more stable because the various components
are more likely to move in the same direction in a given month. In particular, we find that the ratio of
shipments to inventories exhibits leading properties for the manufacturing sector as a whole. As
inventories decline relative to shipments, there is a greater likelihood that manufacturers will need to step
up production to stabilize inventory levels – and hence a greater likelihood that overall manufacturing
activity will turn up in subsequent months (see “Taking Stock of Cyclical Sectors—Inventory/Sales Ratios
in Housing and Industry,” US Daily, March 27, 2006 for a lengthier explanation). By combining this
observation with the first point above and looking at longer term percentage changes in the
shipment/inventory ratio, we derive a statistically significant leading indicator for the monthly Institute for
Supply Management manufacturing index. Both the 6- and 12-month percentage changes in the durable
goods shipment/inventory ratio bottomed in January and have improved meaningfully since then; the 6-
month annualized change has improved from -33.4% in January to -8.8% in June. This is one of several
factors that suggest to us that the ISM manufacturing index should rise above 50 in the next few months.

Andrew Tilton