Short-term Investment Strategies for the U.S. Service Sector

Looking to get a glimpse into the future of the U.S. economy to better position your portfolio? 

The Institute for Supply Management of Tempe, Arizona, has some statistics that might prove useful in identifying which sectors are likely to outperform over the short term – published in their monthly Non-Manufacturing ISM Report on Business, released on the third business day of each month.

Expansion in Non-Manufacturing

The Institute’s latest NMI reading of 53 percent for the month of December shows the non-manufacturing segment of the economy is still growing, though at a slightly slower pace than November’s 53.9 percent number. As readings over 50 percent indicate expansion, December marked the 48th consecutive montthh of growth for the non-manufacturing group of industries.

Of the non-manufacturing sectors comprising the NMI, eight industries reported growth in December, they being: Management of Companies & Support Services, Retail Trade, Other Services, Finance & Insurance, Public Administration, Construction, Information, and Health Care & Social Assistance.

Meanwhile, eight other non-manufacturing industries reported contraction, these being: Mining, Arts Entertainment & Recreation, Educational Services, Transportation & Warehousing, Real Estate – Rental & Leasing, Utilities, Wholesale Trade, and Accommodation & Food Services.

Three Components – Two Up, One Down

To help us get a better idea of which industries deserve our investment attention, the broader NMI index is further broken down into three sub-indices – two of which saw growth in December, while the third bucked the trend with a contraction.

• The Employment Index marked its 17th consecutive month of expansion at 55.8 percent in December, picking up speed compared to November’s 52.5 percent number.

• The Non-Manufacturing Business Activity Index recorded its 53rd consecutive month of expansion in December at 55.2percent, albeit at a slightly slower rate of growth than November’s 55.5 percent reading.

• The New Orders Index, however, has bucked the expansion trend. After 52 consecutive months of expansion, the NOI fell significantly in December to 49.4 percent, falling a stunning 7 percent from November’s 56.4 percent, and is currently below 50 percent, indicating a shrinkage of new orders.

“Despite the substantial decrease in the New Orders Index,” the Institute summarized in its report, “respondents’ comments predominately reflect that business conditions are stable.” Here’s how some of the respondents assessed their industries:

• Management of Companies & Support Services: “Hiring activity seems to remain steady at mid- to senior-level management positions.”

• Construction: “Business is steady. We are at year-end and the holidays, so it’s a little quiet. Expect things to pick up after the first of the year.” (Remember, this report was for December, and included the holidays.)

• Arts, Entertainment & Recreation: “Early, severe winter weather has had a major impact on business. Both customers and employees were unable to reach the workplace.”

• Wholesale Trade: “Overall, we are still seeing the pickup in business which began in the 3rd quarter.”

Looking to New Orders

While most of the report’s data is backward-looking, we as investors are keenly interested in the report’s forward indicators to better position ourselves in the sectors that are expected to perform the best. For that we need to look at the New Orders Index.

Six non-manufacturing industries reported increased new orders in their pipelines. Here they are – listed in order of greatest expansion:

1. Management of Companies & Support Services
2. Retail Trade
3. Information
4. Public Administration
5. Construction
6. Finance & Insurance

Meanwhile, 11 industries reported contractions in new orders, namely: Mining, Arts Entertainment & Recreation, Transportation & Warehousing, Educational Services, Real Estate – Rental & Leasing, Utilities, Wholesale Trade, Other Services, Accommodation & Food Services, Health Care & Social Assistance, and Professional, Scientific & Technical Services – listed in order of greatest contraction.

This gives us an idea of which sectors to buy, and which to avoid. But we need to keep in mind that there is a wide range of delivery time horizons from industry to industry. For example, orders within the Retail Trade sector could be due for delivery within days to weeks, while orders in the Construction sector could be due for delivery in several months or quarters. So while investing in both of those sectors might be alright for now, the good times in one sector may not last as long as the good times in another sector.

At the same time, the 11 industries that saw shrinking new orders do not use uniform time horizons either. While bookings in the Arts, Entertainment & Recreation sector are typically slow this time of year, given the colder January and February weather, reservations can pick up rather quickly come the spring. Whereas mining could see its slump continue for several quarters.

Perhaps a solution is to update our “Hot Sectors” and “Cold Sectors” lists monthly, knowing that each sector has its own time horizon in forward-looking new order bookings.

Hot Sectors to Look At

For now, based on the December data, it would seem the six industries with expanding new orders would make great places in which to put a little extra money to work for us, as they will likely report better Q4 and Q1 earnings numbers over the coming months thanks to their pre-sold activities.

Since each industry represents hundreds of publicly traded companies, investors might be better off going with sector ETFs or mutual funds. So let’s go through some of the non-manufacturing industries that reported new order growth in December and try to match them with an appropriate fund.

• Retail Trade: This is an easy one to match, with many retail sector ETF’s to choose from, such as the SPDR S&P Retail ETF (NYSE: XRT). The fund’s top five holdings are Groupon (NASDAQ: GRPN), SuperValu (NYSE: SVU), Overstock (NASDAQ: OSTK), The Finish Line (NASDAQ: FINL) and Brown Shoe Company (NYSE: BWS).

• Construction: For this industry we could try the SPDR S&P Homebuilders ETF (NYSE: XHB). Its top five holdings are D.R. Horton (NYSE: DHI), Lumber Liquidators (NYSE: LL), Toll Brothers (NYSE: TOL), Ryland Group (NYSE: RYL) and PulteGroup (NYSE: PHM).

• Information: For this sector we might go with the PowerShares Dynamic Media ETF (NYSE: PBS). As Yahoo! Finance describes it, “The fund generally will invest at least 90percent of its total assets in common stocks of media companies that comprise the underlying intellidex… composed of common stocks of 30 U.S. media companies. These companies are engaged principally in the development, production, sale and distribution of goods or services used in the media industry.” The fund’s top five holdings are CBS Corp (NYSE: CBS), Walt Disney (NYSE: DIS), DISH Network (NASDAQ: DISH), Time Warner (NYSE: TWX) and Google (NASDAQ: GOOG).

• Finance & Insurance: For this industry we have several options. There is the overall financial services ETF Financial Select Sector SPDR (NYSE: XLF) which invests in “diversified financial services; insurance; commercial banks; capital markets; REITs; consumer finance; thrifts & mortgage finance; and real estate management & development”. (Yahoo! Finance) It’s top five holdings are JP Morgan Chase (NYSE: JPM), Wells Fargo (NYSE: WFC), Berkshire Hathaway (NYSE: BRK.B), Bank of America (NYSE: BAC) and Citigroup (NYSE: C).

Or we can subdivide the industry into banking and insurance separately. For banking we might go with the SPDR S&P Bank ETF (NYSE: KBE), whose top five holdings are Texas Capital Bancshares (NYSE: TCBI), BancorpSouth (NYSE: BXS), Northern Trust (NYSE: NTRS), Webster Financial (NYSE: WBS) and Synovus Financial (NYSE: SNV).

For insurance we might try the SPDR S&P Insurance ETF (NYSE: KIE), whose top five holdings are Fidelity National Financial (NYSE: FNF), XL Group (NYSE: XL), PartnerRe (NYSE: PRE), MBIA (NYSE: MBI) and Old Republic International (NYSE: ORI).

While most economic data released throughout each month is backward-looking, and shows us only where we have come from rather than where we are heading, there are those few forward-looking data which can provide an expectation of the economy’s future performance. The Institute for Supply Management’s Non-Manufacturing New Orders Index can be one such forward-looking report to help us catch a glimpse into the future.

But with each investment choice, there is always the risk of adjustments or amendments to data which could send our entire line-up of investments into disarray from one month to the next. Whenever using any report or index as a guide, we should always balance the risk with proper diversification into other sectors or markets.

No tradesperson would ever show up at a job with just one tool in their hand, but will always have an entire assortment of tools at their disposal. Investors should likewise be ready with multiple tools of their own.

Joseph Cafariello