Is it as good as the ISM says?

PORTFOLIO POINT: The ISM has rebounded well ahead of other indices, which could be good news, or it could be misleading the revival.

The ISM index – produced by the Institute for Supply Management – is the indicator du jour. It has rebounded sharply, along with its global counterparts. Markets are following this lead. However, the ISM is now out of sync with most other macro data.

The index is calculated from a survey of purchasing executives across about 300 US industrials. Although it is a leading index, other indicators are much weaker than they usually are when the ISM breaks through 50, as it recently has. Either the ISM is leading the rest of the macro data by an unusually long way, or it is not representative of the broader recovery.

The ISM is now above the 50 expansion/contraction threshold for manufacturing. Historically, the expansion/contraction threshold for GDP is about 44.

(The ISM gauges purchasing activity, tracking new orders, production, employment, supply deliveries, inventories, prices, export orders, imports and order backlogs.)

If that's not spicy enough, the data can be tortured to confess to an even stronger rebound: the gap between new orders and inventories, for example, has surged (Exhibit 1).

The ISM survey includes a specific production component, so it seems unnecessary to concoct another indicator, such as orders-inventories.

Since 1970, the correlation between the production component and the six-month change in manufacturing production has been 75%; the correlation with orders-inventories is 39%. So the concoction has a worse track record than the production index has.

Markets are following the ISM's lead. Consensus earnings revisions usually follow the ISM, and they are rebounding along with the index, although, as Exhibit 2 shows, it seems that earnings forecasts were cut too far at the lows, enhancing the subsequent rebound.

Likewise, sector performance is following the ISM script. Exhibit 3 shows the performance of US equity sectors in this cycle from the ISM trough to its breaching 50.

nExhibit 3: Sector performance follows the ISM script
		Median annualised relative return, ISM Cycle
S&P 500 Industry Group	Current trough to 50	Trough to 50	50 to peak	Peak to 50
Median Duration (mos)	8	5	10	10
Semi & Semi Equip	49.90%	39.40%	-0.80%	-6.00%
Consumer Services	-7.50%	36.00%	9.90%	-0.30%
Software & Services	26.80%	28.40%	-10.40%	3.70%
Autos & Comps	121.20%	23.70%	8.50%	0.30%
Cmmerc'l Srvcs & Suppl	-16.60%	18.10%	2.60%	-7.40%
Materials	27.70%	16.20%	6.00%	7.30%
Consumer Durables	12.30%	11.70%	-0.80%	-2.50%
Food & Staples Retailing	-15.40%	11.10%	-15.40%	2.40%
Retailing	29.40%	10.50%	2.80%	-2.40%
Tech Hardware & Equip	51.60%	10.10%	5.50%	-0.20%
Capital Goods	-11.40%	10.10%	7.10%	-1.20%
HC Equip & Services	6.80%	6.80%	7.30%	1.70%
Diversified Financials	33.70%	5.20%	1.30%	1.40%
Media	4.40%	4.50%	-9.30%	0.00%
Transportation	-9.00%	-0.60%	13.90%	-1.20%
Insurance	-0.20%	-1.30%	2.30%	10.70%
Banks	-30.70%	-3.00%	1.00%	2.60%
Food Bev & Tobacco	-9.10%	-4.00%	8.90%	11.00%
Energy	-15.70%	-4.50%	7.70%	1.30%
Pharma & Biotech	-16.50%	-9.10%	-2.50%	9.70%
Utilities	-19.20%	-10.70%	-2.50%	1.80%
Hsehld & Prsnl Products	-28.40%	-14.00%	13.90%	0.80%
Telecom Services	-27.20%	-17.40%	-8.40%	7.20%
S&P 500	21.60%	23.10%	17.70%	-5.80%
Median returns (three right-hand columns) based on 10 prior ISM cycles since 1945. Source: Global Financial Data, FactSet, Morgan Stanley Research

There are also historical data on sector performance for three phases: 1) from the ISM trough to 50; 2) from 50 to the ultimate peak, and 3) from the peak to when the ISM fell through 50. The historical data are based on 10 cycles from 1945. The sector performance now has followed the typical cycle, with the notable exception that consumer-related sectors have underperformed.

So far, so good. But here's what's different: Almost every other notable macro indicator is significantly weaker now than is usual when the ISM breaks 50. Exhibit 3 shows the history.

Two examples: Typically, when the ISM breaks 50 from below, retail sales are up 2% on year-ago levels, but this time they are falling by 8%; likewise, payrolls have usually started to rise when the ISM breaks 50, but this time the three-month average has fallen by 331,000.

In short, the ISM in this cycle is not in sync with other cycle indicators. This may be because the ISM is leading by an unusual distance.

Or it may be that the ISM is capturing the relatively narrow range of swing factors: the turn in inventories, cash for clunkers, and the rebound in global manufacturing from the post-Lehman disruptions.

Put another way, markets have responded to the one high-frequency data series that is signalling an aggressive macro rebound.

If the ISM is sending a misleading signal on the robustness of growth through to 2010, then equities will face a setback if the rest of the economy does not follow through on the ISM's lead. If the ISM falters and then falls (possibly from higher levels than now), it would, in our view, be an important signal that the current rally is in danger of a material setback.

Gerard Minack is head of global developed market strategy at Morgan Stanley.