The recent contraction in the Institute of Supply Management (ISM) Manufacturing Index—the most reliable economic indicator we have—for August confirms that the economy is weakening, writes Landon Whaley.
I have a carefully curated list of what I refer to as “desert island” data sets. This is the data I want to be delivered if I’m stuck on a desert island and could only have a handful of data sets airdropped in once each week to drive my investing decisions. The Institute of Supply Management (ISM) Manufacturing Index is at the top of that list because, historically it’s been a very accurate indication of the future trajectory of economic growth.
Last week I said, “The August data slowed for the seventh time in the last 10 months, hitting a contraction-worthy 49.9. August was also the worst Markit Manufacturing PMI reading (and the first contraction) since September 2009. This data set is forecasting a likely contraction in the ISM Manufacturing PMI (reported this coming Thursday).”
Sure enough, the August ISM reading hit a contraction worthy 49.1 and has now slowed in five straight months and eight of the previous 11 months. The August reading is also the first contraction, and the slowest pace of activity, in the last three years. But this wasn’t just a headline problem, the new orders sub-index hit a brand new 124-month low (lowest in 10 years) and was accompanied by contraction in numerous other sub-indices including current production, employment, inventories, backlogs, exports, imports and prices.
Historically, once the U.S. yield curve (10-year minus three-month) inverts, the ISM enters contraction an average of seven months later. The “10-year minus three-month curve went negative on March 22, and here we are (almost right on time) five months later watching the ISM contract. Based on the last eight 10-year minus three-month inversions, the ISM tends to find a floor 19 months after the curve turns negative, which means the ISM should bottom around next September. Now that the ISM is officially below 50, the other historical “if this, then that” at play is that the Fed engages in multiple rate cuts. On average, they cut five times, but they cut an average of eight times when the U.S. enters a recession post-ISM contraction.
Folks, I’m not perma-bearish, I’m perma-pay attention to what’s happening right in front of me and trade accordingly. The Federal Reserve can go sell the idea that the economy expanded at a modest pace through the end of August to the perma-bulls, but I ain’t buying. The Fed’s obsession with levels instead of the far more critical rate-of-change (ROC) in economic data doesn’t change the Winter Fundamental Gravity enveloping the U.S. economy and its markets. Further, don’t fall prey to the fear of missing out (FOMO) induced by the two-day risk rally catalyzed by a claim that China will meet with the U.S. trade representatives someday (to be determined) over a month from now.
The bottom line is that whether the Fed or the FOMO crowd want to acknowledge it, it’s a Winter Wonderland in the United States. Trade accordingly. On the long side, we’ll continue to focus on buying REITs, utilities, and Treasuries (all durations) on pullbacks while opportunistically shorting financials, retailers, basic materials, and small-cap stocks.
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