Wednesday, March 7, 2012

Business cycle tracking method spots downturns - SDM Pulse, Spring 2012

By Felipe Bustos, SDM ’11


Problem statement: Although manufacturing represents 12% of the US economy and the Obama administration is emphasizing manufacturing as a way to stimulate the creation of highquality jobs, most data related to manufacturing are expensive and suffer from inherent biases.
A new metric: For their thesis project, Bustos and co-author Fernando Barraza, SDM ’10, developed a metric that characterizes US manufacturing using a simple, yet meaningful, mathematical representation derived from public data.
The metric, Manufacturing Composite Index of Leading Indicators (MCI), taps data from the US
Census Bureau and the US Bureau of Labor Statistics that includes:
time series for new orders
shipments
total inventory
capacity utilization
average weekly hours of manufacturing
Initial findings: After several months of intensive data mining, Bustos and Barraza compiled graphs plotting the MCI against GDP for several subsectors. When they benchmarked the Primary Metals subsector MCI against the US Manufacturing Gross Domestic Product (GDP), they found that this MCI anticipates fluctuations in the GDP by 5 to 9 months. They had found a metric capable of signaling recessions.

Figure 1. This chart shows the correlation between
the MCI and US manufacturing GDP. The MCI anticipates
the GDP by 5 to 9 months.
 The MCI would have indicated the recessions of 2001 and 2007/2008 well before the official government declarations. For example, the 2001 recession began in March and ended in November of that year. The official declaration was not issued until November 26. The MCI would have given its first warning of the recession in March.
The MCI correlates with GDP on 18 of 20 manufacturing subsectors defined by the North American Industrial Classification System. In looking at industry subsectors, Bustos and Barraza found that some lead their respective GDPs more than others. Food products, petroleum and coal products, primary metals, and fabricated metals turn out to be prime movers in manufacturing.
Using the MCI
Businesses can use the method as a management tool in several ways:
delaying expansion or acquisition plans to wait for better prices
renegotiating contracts for raw materials
adjusting hiring plans
decreasing capacity utilization to reduce inventory
shifting sales strategies

Figure 2. This chart shows the Inventory Coverage index for the Machinery
Manufacturing subsector. The green band is the safe zone for inventory
levels and the pink band is the warning zone. The blue line is the industry
average. The yellow and green lines are Caterpillar’s and John Deere’s
inventory levels respectively.

In addition, investors can use the MCI method to adjust their valuations of companies.
Businesses can also create Inventory Coverage indexes for each subsector. These allow businesses to identify safe inventory levels for their sectors, track how their sectors perform against this benchmark, and react accordingly.
The research work that Bustos and Barraza conducted demonstrates how a systematic approach to data analysis can offer significant understanding of fluctuations in the complex US manufacturing economy.
About the Author
Felipe Bustos is a Captain in the Chilean Air Force. He serves as an advisor to the CEO of Empresa Nacional de Aeronáutica (ENAER), the Chilean national aircraft maintenance, repair, and parts manufacturing company. He recently completed MIT’s System Design and Management (SDM) Program and earned an MS in Engineering and Management.

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