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The manufacturing sector is a small and shrinking gear in the US economic engine, and yet the ISM manufacturing index seems to have an outsized influence on the US stock market.
The Institute for Supply Management releases its May reading of factory-sector sentiment on Wednesday morning. Economists, on average, expect the index to fall to 57 from 60.4 in April.
This morning’s worse-than-expected Chicago PMI report could mean tomorrow’s ISM reading will also disappoint. Chicago PMI and the national ISM number have a 90% correlation, according to David Ader at CRT Capital. Chicago’s number was hurt by auto-sector slowdowns resulting from Japan’s disasters. Several economists suggested the dismal Chicago PMI reading could translate to a national ISM number of 55 or so.
Whatever the number, it is starting to look like the national ISM index peaked in February at 61.4. And that’s not great news for the stock market. For at least the past decade, peaks in the ISM index have mirrored peaks in the S&P 500.
The year-over-year percentage change in the S&P typically tracks the ISM move-for-move. Sure enough, it has been falling along with the ISM since February.
Given the relative smallness of the manufacturing sector in the economy — it made up less than 13% of GDP at the end of 2009, according to University of Michigan professor Mark Perry — the close relationship between ISM and GDP seems odd at first. But it might not be that odd. Manufacturing is still highly sensitive to shifts in the pace of global growth, and the S&P 500 is dominated by companies that export goods around the world.
The relationship will probably seem to break down in May, mainly because the S&P was so beaten down in May 2010 that it will enjoy a big year-over-year jump in May 2011. But the market did fall further in May relative to February. If the ISM keeps sliding, then stocks could keep falling, too.
The chart above, which we lifted from Tim Iacono and updated today, puts the relationship in sharp perspective.
Further reading: Dave Kansas’s post on the relationship between the Dow and GDP
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Of course the markets pay close attention to the manufacturing segment of the economy. The strength of the manufacturing sector is the best measure of a country’s ability to create true wealth. Look at China: Real wealth comes from producing things that add value to otherwise useless objects. Cars, locomotives and tractors from rocks (iron ore), houses and buildings from rocks (limestone & iron ore), electric power from more rocks (coal) and plastics and fuels from sticky stuff (oil). We can live without most services, and much of the world does. Agriculture also creates real value out of something else useless: Something to eat from dirt. Banks, legal services, hospitality investments and restuarants are nice but are a symptom of wealth. They create no wealth, they only consume wealth.
Why the confusion? The economic fact is… manufacturing is the ONLY thing that matters! Read Adam Smith. You cannot have an economiy by consuming Chinese goods. You cannot have an “information” economy. You cannot have a service economy. The only thing that wags the needle is MANUFACTURING. There is no mystery.
MarketBeat looks under the hood of Wall Street each day, finding market-moving news, analyzing trends and highlighting noteworthy commentary from the best blogs and research. MarketBeat is updated frequently throughout the day, helping investors stay on top of what's happening in the markets. The Wall Street Journal's Chief Markets Commentator Dave Kansas and MarketBeat lead writer Matt Phillips spearhead the MarketBeat team, with contributions from other Journal reporters and editors. Have a comment? Write to marketbeat@wsj.com or write Dave at dave.kansas@wsj.com or Matt at matt.phillips@wsj.com.
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