Is That There Is?

Up until the time that the combination of unrest in the Middle East and a spike in oil prices captured the stock market’s attention, it was the prospect for economic growth in the U.S. that was the focal point. And while today traders watch each and every tick in the oil pits in order to determine their next move, before February 22nd, it was the economic data that drove the direction of trading.

We bring this up because at some point, the attention will likely return to the idea of growth in the developed nations of the world. If you will recall, it was the concept of improving expectations for the economy here at home that helped drive stock prices up nearly 28% from September 1, 2010 through February 18, 2011.

With the bull market likely to celebrate its second birthday at this time next week, we thought it might be a good idea to look at what we might be able to expect going forward. Of course, in order to do so, we’re going to have to make an assumption or two.

First and foremost, we are going to assume for a moment that the current difficulty driving oil prices higher will be resolved and not impact the expectations for global economic growth. In short, if this is not the case, then all bets are off and we can toss any historical studies out the window.

However, if oil can calm down, then we can look back at history to see where we are in terms of the economic cycle. And the good folks at Ned Davis Research are out with a report that might run counter to the consensus view on what may happen next in both the economy and the stock market.

During the current economic cycle, there has been a great deal of focus as well as a fair amount teeth gnashing over the amount of job creation. And it is a safe bet that Friday’s Nonfarm Payrolls report will once again demand a great deal of attention.

However, before jobs can be created, companies have to (a) feel good about the business environment and (b) have the money to commit to new hires. In other words, once corporate America becomes confident that things are going well again, the jobs will come.

It is for this reason that we have reviewed each and every economic report with a fine toothed comb during this recovery phase. In doing so, it has become abundantly clear that the PMI (Purchasing Manger’s Index) data from the Institute for Supply Management has been a key report each month.

The concept here is simple enough. The ISM/PMI report is derived from the guys and gals within companies across the country that order stuff for their companies. It follows that if the purchasing managers need to order more stuff, then business must be good. And if they are ordering less stuff, well, you get the idea. (Don’t you love it when economics actually makes sense?)

Thus, the ISM/PMI data has been a big deal for many months now and clearly illustrated the turn in the economy before everyone else saw it.

So, with the ISM number having climbed from the Great Recession low of around 33 to its current reading of 61.4, which, by the way, is the highest level since 2004 and you have to go back into the 1980’s to find a higher level, we wondered what happened to the economy/stock market going forward.

The bottom line is that when the ISM Report for Business has been above 60 in the past, stock prices haven’t done very well. In fact, according to NDR, the S&P 500 has actually fallen at a rate of about -1% per year when the ISM has been above 60 since 1948.

Why would this be, you ask? Basically, we need to remember that the stock market is a discounting mechanism. And although the ISM is an excellent tool in helping us identify the turn in the economy, it becomes less valuable going forward because the stock market usually races ahead when the economy begins to improve.

The move from September to the middle of February is a perfect example. The economy and the ISM data didn’t improve dramatically during that period of time, but with traders looking to blue skies ahead, stocks popped up 28% in less than six months.

The takeaway here is to understand that the market is currently in the process of discounting those blue skies. And at some point, it will go too far. (I know; how could Wall Street ever overdo anything?) As such, we need to recognize that we may soon be entering the last leg of the current joyride to the upside and that the next really big move might represent the discounting of a slowdown in the economy.

Granted this is VERY big-picture stuff. But given that the S&P 500 rose +98.5% from the March 9, 2009 low through February 18th, we can’t assume that more good news from reports such as the ISM will mean more big gains.

 

  S&P 500 - Last 5 Years

 

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