In case you've missed it, the ISM Manufacturing Index has been below the proverbial 50 mark for the past 4 months.
Widely watched as a gauge for recession, the ISM has been shouting an economic slowdown for the past 4 months. In fact, this is one of the longest slowdowns below 50 in the index since the financial crisis of 2008 and the recession and dot-com bust of 2000. In the other words, something's afoot.
As investors, we must engage in second order thinking. A first order thinker says, "The ISM Manufacturing Index is below 50 - sell something!" A second order thinker says, "The ISM Manufacturing Index is below 50 - let's research correlations, understand causations, and if an asset is attractively priced, take a position." Let's do some second order thinking.
To understand why the ISM is falling and what that could potentially mean for investors, we must go on a journey. Like many stories, ours begins with the Federal Reserve. You see, for the first time in 7 years, the Federal Reserve recently increased rates. The significance of this increase on global asset valuations cannot be overstressed.
When the Federal Reserve increases rates, the economy is squeezed. The squeeze works like this - companies pursue projects based on estimated internal rates of return versus a risk-free benchmark rate. When the risk-free benchmark rate increases, companies must pursue projects which offer only the highest returns to avoid making a poor economic decision. The Federal Reserve just increased interest rates, which increases the internal discount rate at many companies, and therefore results in fewer projects pursued. An economy with fewer projects pursued will see a slowdown in manufacturing. What does a slowdown in manufacturing do for the strength of the currency in which the manufacturing is priced? Let's find out.
The chart above shows the relationship between a 12-month percent change in the ISM Manufacturing Index and the dollar index (NYSEARCA:UUP). What do you see?
An inverse relationship exists between the dollar and the ISM Index. When manufacturing falls, the dollar tends to rise. Conversely, when manufacturing is increasing, the dollar tends to fall. This is a pretty strong relationship and makes economic sense only when you dig into it.
You see, the economy moves in cycles. There are opposing forces which exert influence at different stages of the business cycle which impact and provide catalysts to other forces. Specifically, when the dollar is gaining strength, manufacturing tends to suffer since exports decrease due to the relative price of domestic assets to foreign purchasers. In other words, products get more expensive versus alternatives to those who would provide demand for the dollar. When the dollar is strong, exports and manufacturing suffer. That's the cycle we've seen for the past 2 years - the dollar has been increasing in strength and manufacturing has suffered. But we're nearing a turning point.
When the Federal Reserve increased interest rates, it set off a chain reaction with traumatic ramifications for the strength of the dollar. I'll get straight to the point - every time the Fed has increased rates following a prolonged period of low, stable rates, the dollar has declined over the next 2 years. In other words, the dollar is probably going to fall. In fact, it's already started its descent. As the dollar falls, manufacturing will inevitably rise.
At the moment, we're actually seeing this relationship unfold - manufacturing is starting to bottom out and the dollar has started to fall. The counteracting forces of fewer projects pursued and a weakening dollar look to be nearing an apex. In other words, the dollar is probably going to keep falling and manufacturing is more than likely bottoming out. It's time to short the dollar.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EURUSD over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I will capitalize on this opportunity in the short-term trading a variety of dollar-based currencies.