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Positive ISM Surprise Bodes Well Medium Term Statistically

|Includes: DIA, QQQ, SPDR S&P 500 Trust ETF (SPY)
The stock market has gone through a roller coaster ride since the VIX reached its 52-week low of 20.1 on Oct 21. In just 5 days, VIX shot up to 31, and the S&P 500 pared over 6%, during which GDP reported 3.5% for Q3 and ISM index posted a surprise jump to 55.7. Today, VIX came off from the recent high while major indices posted mixed results. The industrial, materials and financial sectors switched to lead, signaling a gradual return to risky assets. In the short-term, I believe the panic state is over. With some questions on the valuation of the stock market, it is possible that major indices may trend down slightly, but shouldn’t be severe.


More importantly, I don’t expect a double dip unless the overall economic situation changes dramatically. The reasons to remain positive at this time are:
- October ISM index came out yesterday to be much stronger than expected at 55.7, and the employment component jumped to 53.1, registering the first month of growth following 14 consecutive months of decline.
- S&P 500 valuation is fair to slightly overvalue. With economic recovery underway, and credit spreads continue to narrow, it is not very likely to trigger another bear market at this point.
- Over 80% of 300+ S&P 500 companies that reported to date for the past quarter meet or beat estimates. Businesses have been very aggressively managing top and bottom lines and profitability remains strong.
- Record low interest rate is one of the most powerful force to crank start a weak economy. With low inflation for the foreseeable period, the Fed won’t be forced to raise interest rate.
- As many economists including Noble Prize winner Paul Krugman pointed out, the stimulus is not enough. But it appears the government is determined to continue its effort in stimulating the economy. Although many are concerned about the consequences of money printing down the road, the US inflation should remain subdued for quite some time until employment situation improves.
If history is the mirror, I’d like to delve a little bit deeper into the past. The following charts present since 1975 the ISM index series and the subsequent S&P 500 returns in 3 month, 6 month and 12 month, respectively. The question I’m trying to answer is: historically, when ISM index is as high as 55, how does the stock market perform subsequently, and how often does it happen that the stock market enters the bear market subsequently?
The answer is: an ISM index of 55.7 is a very healthy number and the stock market subsequent performance has a much higher chance to be positive, rather than diving backing into the bear territory.
With that said, let me elaborate with a little bit more details.
The horizontal lines in the middle of the charts mark the ISM index level of 55 and the S&P 500 index zero return.
For the 3-month chart, we can see that the subsequent stock market returns are almost always flat to positive with the only exception of the 1987 crash. On the 6-month chart, the exceptions are the 1987 crash and the 10% decline May 1983 to April 1984. On the 12-month chart, the exceptions are again the 1987 crash, the May 1983 – April 1984 decline, and the 2000 stock market crash.
On a case by case basis, I don’t think the current situation is comparable to the time prior to the 2000 stock market crash, neither do I believe the mysterious 1987 stock market crash will happen again. The 10% slip May 1983 – April 1984 was accompanied by hyperinflation, which isn’t an issue now.  


 

Certainly history never completely repeats itself, and every recession is different. I would remain cautious, watching out for any major slowdown in the economic activities over the next few months, which is key at a time stimulus spending slows.