US manufacturing is booming.
In a report released this week, the ISM Manufacturing Index moved up to 61.3, the second-highest level in the last 30 years.
Data Source for all charts/tables herein: FRED, Bloomberg
Many are saying that’s great news for the stock market because increased manufacturing activity is evidence of a stronger economy. This seems logical but does the data support such a conclusion? And is it prudent to use manufacturing indicators to time your exposure to stocks.
Let’s take a look…
1) Is there evidence of outperformance in stocks following the highest ISM Manufacturing levels?
If we sort the ISM Manufacturing Index (going back to 1948) into deciles and compare the highest and lowest 10% of readings, we find above-average returns following the weakest readings and below-average returns following the strongest readings (highlighted row).
Over the subsequent year, the weakest ISM readings were followed by an average S&P 500 return of 25.6% versus a return of 5.5% for the strongest ISM readings. There is simply no evidence to justify a more bullish outlook on stocks following the strongest ISM readings.
2) Should you use ISM Manufacturing levels to time your exposure to stocks?
ISM Manufacturing readings above 50 indicate increased manufacturing activity while readings below 50 are said to indicate a contraction in activity.
Some pundits say you should only own stocks when ISM is above 50. Others say that you should look at the rate-of-change, and only own stocks when the ISM is positive year-over-year.
Going back to 1948/1949, how would these two strategies have fared versus a simple buy-and-hold? In both cases, far worse.
Note: in the “PMI YoY Strategy” you are buying the S&P 500 when PMI is positive year-over-year and selling the S&P 500 when it is negative year-over-year. In the “PMI Above/Below 50 Strategy” you are buying the S&P 500 when PMI is above 50 and selling the S&P 500 when PMI is below 50. For simplicity, this analysis ignores commissions, slippage, and taxes.
Why isn’t the ISM a good indicator for timing stocks?
There are certainly times when the ISM is weak and stocks continue to move lower, but there are also many times where ISM is exhibiting weakness (below 50 or down year-over-year) without ensuing stock market declines. Oftentimes, the stock market is already reflecting such weakness as the two variables are correlated (0.48 correlation between year-over-year changes in ISM and S&P 500). By the time the ISM data gets better again, the stock market may have already rallied, causing a whipsaw for investors that sold and now have to buy back in at higher levels. This assumes that the two variables move in tandem, which is not always the case (the correlation is far from perfect). There are plenty of examples where the stock market has ignored the current ISM reading altogether, focusing instead on other economic data points or looking ahead to better/worse future ISM reports.
Needless to say, there is no simple rule of thumb when it comes to ISM levels and what they may imply for the stock market.
Does that mean manufacturing activity is unimportant to the economy? No, just that using it to time your exposure to stocks does not appear to be an effective strategy. The fact that the best performance from stocks has historically come after the worst manufacturing readings tells us as much. The stock market is not the economy.
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