Reading the economists' comments in response to today's ISM report (which, incidentally, missed expectations) one would think that the US has practically entered a second golden age. Here is a sample:
- Manufacturing index "has now stabilized at a level reflecting a solid pace of expansion," Thomas Simons, economist at Jefferies, writes in note
- June data consistent with Barclays estimate of 2Q GDP growth rate of 4%, according to note from Cooper Howes, economist at firm.
- June’s reading of 55.3 “has to be viewed as a good result, even if it was lower than expectations,” Rob Carnell, economist at ING, writes in note
- ISM index shows factories humming along in Q2, according to UBS
- And especially this one from TD Securities: Increase in new orders, as tracked by ISM factory report, is "especially encouraging as it augurs very well for future manufacturing sector activity"
So what exactly are all these "experts" looking at to be so convinced, once again, that the "imminent" economic surge that thay have all been predicting for so long, incorrectly, is finally here.
The answer - the all import New Orders index - the key driver of the headline ISM print and the one most important sub-headline index. And if we were also simply looking at the reported number of 58.9, which printed at the highest level since December, we too would assume that the US economy is finally rebounding.
Alas, here lies the rub: what none of the abovementioned experts realize is that for some inexplicable reason, the ISM survey is, just like the vast majority of all other economic indicators, also seasonally adjusted.
Recall that it was ISM's seasonal adjustment SNAFU last month, when it used the wrong "adjustment factor", that caused the reported number to become a humiliating farce after the ISM had to revise it not once but twice with what ultimately ended up being a "factor" leading to a far higher, and consensus expectation-beating, headline ISM print of 55.4.
But what really happened in June? For the answer we need a refresher of just how the ISM survey results in reported numbers.
What the ISM does is ask respondents to comment on how they are seeing any given query category as performing in the current month. The response options are simple: better, same, or worse.
The ISM then takes the percentage of "better" responses and adds half the percentage of "same" (ignoring the worse answers) for any of the following categories:
- New Orders (58.9 in June)
- Production (60.0)
- Employment (52.8)
- Delivery Time (51.9)
- Inventories (53.0)
Then it simply takes the equal-weighted average of these 5 series and gets the final number (in the case of June 55.3 down from May's adjusted 55.4).
However, before the final tabulation, the ISM also applies a little-known seasonal adjustment factor to the actual unadjusted survey reponse result before getting a seasonally adjusted number that feeds into the above calculation. Why a survey needs to be seasonally adjusted - considering it merely captures sentiment which already reflects the periodicity of the seasons when it is, well, experienced - is beyond the scope of this article, and/or logic.
What adds to the confusion is that for some unknown reason, in June of 2013 the seasonal adjustment factor (1.051) actually subtracted from the unadjusted number (converting 54.5 into 51.9), while in June of 2014 the factor (0.976) managed to add to the unadjusted number of 57.5, making it appear the abovementioned highest for 2014 print of 58.9. Was June of 2014 more "seasonal" than the June from a year earlier?
This is shown in actual practice below:
What the table above shows is the survey responses (courtesy of Stone McCarthy) for the all important New Orders data. The cell highlighted in green, namely the 58.9 June New Orders print, is what the "experts" are looking at. The cells shaded in red is what is relevant: namely what the people are really saying about the economy as it is right now, not adjusted for some arbitrarily assigned fudge factor.
According to the actual data, when it comes to "New Orders" the number of respondents who responded "Better" dropped to 30%, below the 35% in May, far below the 37% in April, and in fact, the lowest since January when the economy was crashing under the weight of "harsh weather." Furthermore, while the number of respondents saying the economy is doing the "Same" rose to 55%, or the highest sinec 2012, those responding "Worse" rose once again to 15, higher than April, and the highest since the "weather impacted" February.
Visually, here is the difference between the Unadjusted and Seasonally Adjusted New Orders survey.
In summary: the actual, and unreported, New Orders number dropped from 60.5 in May to 57.5 in June, which also was the weakest print since January... some improving trend. Compare that to the seasonally adjusted New Orders number of 58.9, the highest of 2014. That's right: thanks to seasonal adjustments what was otherwise a downward sloping trendline, and a print that was the weakest in 5 months, magically was transformed to the best print of the year!
And that is how you fool all of the experts all of the time with something as simple as a completely unnecessary seasonal adjustment factor, which leads everyone to believe that the economy is soaring. Well, it is... on a seasonally adjusted basis, the same seasons that everyone says to ignore when they lead to a -2.9% GDP print!
In reality, the US economy, as represented by actual New Orders surveys, is the weakest it has been since January. And to think- very soon everyone will be shocked, shocked, that Q2 GDP (and Q3, and Q4 and so on) was not nearly as wonderful as everyone had prayed it would be.