Wall Street is always trying to get an edge on where the economy is headed. One of the clues traders look at every month is known as the Philly Fed Report on mid-Atlantic manufacturing.

Officially called the Federal Reserve Bank of Philadelphia's Business Outlook Survey (BOS), the report queries local manufacturers about various aspects of their business and condenses the findings into a series of easy-to-follow indices.

Though it draws information from a relatively small number of employers and focuses on a single industry, the report has been scrutinized by economists and fund managers for decades. Because of the survey’s timeliness – it's released earlier in the month than other closely followed reports – some experts believe it’s an important clue to where the wider business community is headed.

A Look Inside the Survey

The Business Outlook Survey queries manufacturers in eastern Pennsylvania, southern New Jersey and Delaware. Respondents indicate the general direction of business activity, as well as the trajectory of employment, new orders, pricing and other specific measures of activity.

The report also includes a list of “special questions” that vary from one month to the next. These explore a particular area of operations, from hiring to inventories, in greater detail. The percentage of employers with a worsening outlook is subtracted from the percentage of firms showing improvement to create a diffusion index. Therefore, any point in the index above “0” indicates a net positive trend.

While individual measurements – for example, the “average employee workweek” index or “prices paid” index – provide a more nuanced look at what’s happening in the sector, it’s the general activity index that grabs the most attention.

Map of the Third Federal Reserve District.

The Federal Reserve Bank of Philadelphia is responsible for the Third District, which covers eastern Pennsylvania, southern New Jersey, and Delaware.

Source: Federal Reserve Bank of Philadelphia

So why look at a relatively small part of the country when other reports show national data? One of the advantages of the Business Outlook Survey is its early arrival. Numbers are published at 10 am EST on the third Thursday of the month, at least a week and a half before the influential Purchasing Managers Index (PMI) becomes available. For investors trying to stay a step ahead of the market, this is a vital distinction.

Followers of BOS point to the diversity of manufacturing firms in the region, which they believe makes it a microcosm for the industry nationwide.

An Accurate Gauge?

The Federal Reserve System is comprised of 12 regional banks throughout the country. The Philadelphia bank isn’t the only one of these to publish a manufacturing survey, but with a history going back to 1968, its report is the oldest. This extensive track record is one of the reasons why Philly’s research typically garners the most interest.

Of course, not everyone on Wall Street is convinced of the survey’s reliability. A common criticism of the BOS is that its numbers can be somewhat erratic from month to month. Given its relatively small sample size – the bank only uses 150 companies for the survey – perhaps this isn’t surprising.

However, the report’s performance over the long run is remarkably close to that of much much broader economic gauges. A study of multiple manufacturing surveys found that, over time, the Philly Fed Report has had a 74% correlation with the widely followed PMI. And it’s been just as accurate as the PMI when it comes to predicting actual production numbers nationwide.

Another critique of the Business Outlook Survey involves the diminished role of manufacturing in recent decades. In the 1950s, the sector was seen as the engine of the U.S. economy, accounting for 28% of gross domestic product (GDP) according to the Bureau of Economic Analysis (BEA). But with other industries outpacing it – most notably the service sector – manufacturing’s share of GDP as of 2013 was less than 12%. In light of this long-term trend, more skeptical economists question the ability to draw broad conclusions from BOS data.

Though manufacturing certainly isn’t the same economic force it was a half century ago, some believe the survey’s focus on the industry is actually an asset. Their reasoning is that industrial output tends to be sensitive to business cycles, thus providing an early warning of downturns and subsequent recoveries. By homing in on this particular sector, it is believed that the BOS serves as an effective barometer of large-scale swings in the economy.

Indeed, the survey’s data have borne this out. The general activity index has dropped to minus 30 before or during each recession since its inception, including the two recessions since 2000. This consistency over more than four decades is one of the reasons the report still has a loyal following today.

The following chart shows the Business Outlook Survey’s general activity Index between 1995 and 2013. The vertical shaded areas represent periods of recession in the United States.

The Business Outlook Survey’s general activity Index between 1995 and 2013.

Source: Federal Reserve Bank of Philadelphia

Opportunities to Profit

The real question for investors is whether the survey actually moves the stock market. Research into this area, though limited, suggests there is in fact a moderate correlation.

When discussing the BOS, it’s important to understand that expectations for the survey begin to impact the equity market before the actual numbers even go public. And the predictions of various industry professionals – a “consensus” number is available online – can have any even greater impact on trading than the results themselves.

One study, using data between 2008 and 2009, looked specifically at the relationship between the BOS general activity index and monthly changes in the S&P 500, one of the equity market’s broadest measures. While stock values showed a strong correlation with consensus figures (50%) their link with actual BOS figures was somewhat modest (14%).

In other words, if you plan to buy or sell a highly diversified fund – for example, one based on the S&P 500 or Wilshire 5000 – reacting to the Philly numbers gives you a slightly better than average chance of success. But if the index results simply conform with expectations for that month, the effect may be hard to find.

Of course, in today’s investment world, there are those seeking to make a profit not just in hours or days, but within minutes of new economic data becoming public. Toward this end, the online trading platform TradeStation examined the S&P 500 SPDR ETF (NYSE:SPY) just prior to and after the Philly report’s 10 am release to see if any patterns emerge. It used data over a 12-year period, from 2000 to 2012.

Not surprisingly, a BOS index coming in below expectations, on average, led to a 12-minute sell-off, starting at the 10 am release. What’s striking is that above-average survey results, though preceded by a market uptick, were also followed by decline – this time lasting roughly six minutes. So while past results don’t always repeat themselves, there appear to be opportunities to short-sell “whole market” funds regardless of the survey outcome.

These precisely timed transactions are certainly a higher risk-higher reward strategy that won’t suit long-term investors. But for more adventurous types, such findings highlight some of the myriad possibilities for trading on the Philly Fed Report.

The following chart shows an average long position trade when the Business Outlook Survey results beat expectations. A market uptick precedes the survey's release, which is following by a brief sell-off.

Average long position trade when the Business Outlook Survey results beat expectations

Below, a chart showing an average short position when the survey's index comes in below estimates. Here, the release is followed by 12 minutes of decline for the S&P 500, indicating a potential opportunity for short-sellers.

Average short position when the survey's index comes in below estimates.

Source: TradeStation

The Bottom Line

Predicting economic movements based on any single report can be a risky proposition, which is why drawing from multiple sources provides the best chance for long-term success. However, research indicates that the Philadelphia Fed Report has a significant correlation to stock market results and a fairly strong record of anticipating business cycles.