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The ISM Index Could Become The Most “Watched” Indictor

|About: Industrial Select Sector SPDR ETF (XLI), CAT

The ISM manufacturing PMI in the United States has been trending below 50 ever since July of 2019.

But Industrial stocks are ignoring the consistent slowdown in the PMI.

There seems to be a lot baked in the stock prices of these Industrials and it makes sense why all eyes should be on this number for the next 3-5 months.

The ISM manufacturing PMI in the United States has been trending below 50 ever since July of 2019. October marked the 3rd consecutive monthly reading below 50 (at 48.3). But readings below 50 for a few months doe not really suggest an impending slowdown in the coming quarters. In fact, as recently as October 2015 the ISM Index had slipped below 50 and was down for 5 consecutive months before sharply rebounding up. Back then the stock markets had reacted negatively to these poor ISM numbers as the Index (S&P500) corrected around 6% in that period. Most recent ISM Manufacturing readings (red arrow in chart above) are similar to the lows seen in 2015 (orange arrow in chart above), however, the stock markets have not reacted one bit to these fading numbers. Part of the resilience in the markets is due to strong ISM Non-Manufacturing (services) NMI Index but that doesn’t explain the whole story. The Services Index has NEVER traded below 50 since Dec 2009. Even in 2015 when the ISM Manufacturing Index was slumping, this Index was trending above 50 comfortably. So, what explains the stock market’s optimism and what exactly are the markets thinking? The answer lies in the price action in some of the Industrial stocks especially those of Caterpillar’s. CAT’s stock price (yellow chart line) perfectly mirrors the ISM Index (at 0.81 correlation. Many a times Caterpillar’s stock (yellow line) bottoms out or appear to bottom right before an uptick is seen in the ISM Index.

This time around the stock made multiple bottoms and then advanced 8% since August despite ISM PMI numbers trending below 50. The stock is about 4% from its lifetime highs. Further, if you superimpose the S&P500 Select Industrials ETF (yellow line in the chart below) on the ISM PMI graph, the divergence is even greater.

So, what are the markets seeing? Why are industrial stocks being bid up even before any meaningful turnaround in the ISM? While the ISM manufacturing index held below 50 for a third straight month, it posted the first month-over-month increase since March 2019. Key orders and employment components rose from depressed levels in September but remained in the contractionary territory as headwinds persisted. New orders contracted less severely (49.1 vs. 47.3 prior), backlogs declined at an accelerating rate (44.1 vs. 45.1), and production fell to its weakest level in over a decade (46.2 vs 47.3), significantly exceeding the weakest reading in the 2015-2016 soft patch (49.2 in October 2015). Employment declines eased (47.7 vs 46.3). This is consistent with the weak manufacturing payrolls result, concentrated in the autos sector.Is the recent jump in ISM enough to fuel this much confidence? It is clear that investors are ignoring the actual data and pricing in a sharp sharp rebound in the ISM manufacturing as seen in 2015. The reason for this belief stems from the fact that almost everyone on the street believes the poor ISM numbers to be attributable to the trade talks, Boeing’s MAX issues and labor strikes at auto companies. There seems to be a lot baked in these stock prices and it makes sense why all eyes should be on this number for the next 3-5 months.

Samir Gilani