2 Tales Of The Same Indicators

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Includes: RINF, SPY
by: The Macro Trader

As of late we have been seeing the following chart pop up all over our Twitter feed as well as in our inbox. You don't even have to look very closely to see that over the past 20 years the ISM Manufacturing Index and the year over year change in the SP500 have been highly correlated.

This might lead you to believe that we are headed for a doom and gloom bear market and even a recession. After all, an ISM reading below 50 indicates a contraction while readings above 50 indicate expansions. With a reading of 48.2 we are obviously below 50. So guaranteed recession, right? Not so fast.

ISM and SP500 Last 20-Years

ISM and SP500 Last 20-Years

If you look at the above chart again, but closely this time, you can also see that not only does it only cover the time period from 1998-now but that there have been several reading below 50 that did not lead to a recession. If we instead turn our eyes to the next chart of the 10-year correlations of the ISM PMI and the SP500 YoY change we can see that it has only been in the past 10 years or so that the relationship was anything near what it is today.

In fact, right now the correlations are at an all-time high around 80%. Looking at past eras however show that sometimes the relationship has been at 40%, others in the 20% range, and still others displayed a negative correlation. Yes, this means that when the ISM index went negative, sub-50, the SP500 went positive.

ISM-10-Year-Correlations With SP500 YoY Change

ISM-10-Year-Correlations With SP500 YoY Change

If we look at the next chart of the ISM Index and the SP500 YoY, but this time all the way back to the beginning of the ISM data we can see how tenuous this relationship has been over time. Not only has a sub-50 ISM number not been anything close to an automatic recession but it doesn't even mean stocks have to go lower.

ISM and SP500 Full History

ISM and SP500 Full History

Now, could stocks go lower and could we be in a recession? Of course they could and of course we could. The point we are trying to make is that there are so many false positives that you can not overweight this indicator too much in your framework. In fact, if we look over the history of the ISM, or just the history of the economy, we can see that manufacturing is actually less important to the economy than ever before and that this has been a long term trend as we have transitioned towards a service/knowledge based economy.

We don't make stuff if we can have China make our stuff cheaper. In fact, manufacturing currently only represents 12% of GDP and 8.6% of employment in the United States. Seen in this light, and combined with the rest of our business cycle work, we do not see an imminent recession in the United States.

At the same time, according to JP Morgan, manufacturing does account for almost 60% of the profits in SP500 companies. So while the odds of a recession are relatively low the odds of earnings being low and going lower are fairly high. This would not be the first time that we had a correction or even a bear market amidst an expansion.

Don't overweight any indicator more than its history and causality deserves. Don't mistake a mid-cycle correction with a recession or the end of the world. Do take a holistic approach to the economy and look under as many rocks as you can while also figuring out what really moves what. Finally, at least for now, realize that as important as the stock market and the economy are, in the short run, they are not the same thing. Trade accordingly.