US manufacturing is booming.
In a report released last week, the ISM Manufacturing Index moved up to 64.7, its highest level since 1983.
Many are saying that’s great news for the stock market because higher 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 (data 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 25.1% versus a return of 5.6% for the strongest ISM readings.
There is no evidence, then, to justify a more bullish outlook on stocks following the strongest ISM readings. In fact, history has shown us that the exact opposite is true.
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 “ISM Above/Below 50 Strategy” you are buying the S&P 500 when ISM is above 50 and selling the S&P 500 when ISM is below 50. In the “ISM YoY Strategy” you are buying the S&P 500 when ISM is positive year-over-year and selling the S&P 500 when it is negative year-over-year.
Why isn’t the ISM a good indicator for timing stocks?
While there are certainly times when the ISM is weak and stocks move lower, there are also many times where ISM is exhibiting weakness (below 50 or down year-over-year) with no subsequent move down in stocks.
Oftentimes, the stock market is already reflecting weakness in ISM as the two variables are correlated (0.48 correlation between year-over-year changes in ISM and S&P 500). And by the time the ISM data starts to improve again, the stock market has often already rallied, causing a whipsaw for investors that sold and now have to buy back in at higher levels.
This would have been the case in 2020 as the ISM moved below 50 in March (S&P 500 ended the month at 2,584) and back above 50 in June (S&P 500 ended the month at 3,100).
It is also important to note that the correlation between ISM and the S&P 500 is far from perfect. There are plenty of examples where the stock market has ignored ISM readings 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 actually come after the worst manufacturing readings tells us as much. And it provides another instructive reminder that the stock market is not the economy.
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.