Gloomy ISM readings are a good predictor of corporate earnings – but not what the stock market will do

I’m not saying the bear market is over. But if US equities continue to fall, don’t blame the recent drop in the ISM.

The Institute for Supply Management’s manufacturing index – the ISM index – is also known as the Manufacturing Purchasing Managers Index, or PMI. The ISM reflects the results of a monthly survey of purchasing managers from hundreds of US manufacturing companies.

Economic calendar: Nonfarm payrolls and unemployment data are due Friday, along with an update on consumer credit and more

This key indicator of economic health is currently at 52.8 – down from 63.7 at the start of 2021, and its lowest level since the early days of the COVID-19 pandemic lockdown. As my MarketWatch colleague Jeffry Bartash reported, this latest reading is “a sign of creeping weakness in the US economy.”

Many the bears pounced on this last reading reason to expect further weakness in the coming months. They point out, with substantial historical evidence to back it up, that corporate earnings tend to follow the ISM index with a lag of several months.

But that certainly doesn’t mean stocks will follow. The current level of the stock market is already pricing in the poor significance of earnings from the latest ISM report. The bears’ argument would only be justified if they could show that the market consistently ignores or misinterprets this meaning.

Yet, there is no such evidence. Consider what I found by measuring the correlation between the ISM index and the S&P 500 SPX index,
-0.77%.
Focusing on contemporaneous changes in these two indices, I found a significant positive correlation coefficient – 51.3% when correlating 12-month percentage changes since 1948, as you can see in the chart below -below. This is exactly what you would expect from an efficient stock market, rising and falling in sync with measures of economic activity.

In contrast, when correlating the percentage change in the ISM over the past 12 months with the percentage change in the S&P 500 over the next 12 months, the correlation coefficient became negative – minus 12.4%, to be exact. This inverse correlation means that more often than not, the stock market shows above-average performance following sharp declines in the ISM index – and vice versa.

Admittedly, this inverse correlation is only marginally statistically significant. It would therefore be an exaggeration to conclude that the ISM’s recent drop is actually good news for the stock market. But the fact that it is even inverse at all shows that the stock market is more or less immediately pricing in the full economic significance of the new ISM readings and, if at all, slightly overreacting.

No one is arguing that the US economy isn’t weaker than it was in 2021. It undeniably is. But this weakness is already priced into equity prices. The future course of the stock market will depend on whether the economy in the coming months will be stronger or weaker than currently expected.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at mark@hulbertratings.com

After: Most U.S. businesses grow faster in July, ISM says, sign of resilient economy

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