FYI | Jun 20 2011
(This story was originally written and published on Wednesday 15th June, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
By Rudi Filapek-Vandyck, Editor FNArena
When it comes to leading market indicators, none has the track record and the accuracy of the monthly purchasing managers' surveys across the globe, which makes it even more remarkable as to why these surveys enjoy so little attention in market commentaries and strategy assessments in Australia.
Sure, the composition of labour and output has changed dramatically in developed economies over decades past, with the services industry now contributing more than manufacturing, but the accuracy of the forward looking indicators in the monthly PMI surveys has remained intact nevertheless. Many services providers wouldn't have a clue what next month might look like, but manufacturers know what lies ahead well in advance. Which is why the monthly surveys about sales, inventories, new orders, hiring intentions and input costs have remained so useful.
Economists use these surveys to fine tune their forecasts. At times, big changes need to be made. Investment strategists learned a long time ago one simply cannot ignore the trend and forward looking indications from these surveys – because they have a direct impact on what is happening in financial markets.
For equity investors, these surveys are no less than an invaluable tool. Which, it has to be repeated, makes it remarkable as to why these surveys enjoy so little attention in market commentaries and strategy assessments in Australia.
This is not the first time I have written about the correlation between the monthly PMI surveys and the corresponding direction for equity markets. For those looking for more background, I have lined up a few stories from last year at the bottom of this story. I recommend anyone conducting independent market analysis should put some extra homework into this matter, because it will make "reading" the share market a lot easier once the initial work has been done.
Reading the underlying trend in PMI surveys is relatively straightforward: below 50 is negative, because it implies contraction and the deeper below 50, the deeper the contraction. Similarly, above 50 means growth and the further above 50, the higher the growth.
But that's only half the story. More important than the actual outcome of the monthly index is the trend behind the number. Is it going up? Is it going down?
History shows, for example, that when the index sits deep below 50 this can actually be a good time to participate in the share market, even when the trend is still negative. This is because investors at some point start anticipating a reversal for the better which means equity prices start rallying well before this reversal shows up in surveys.
Similarly, when the index sits very high, let's say at 60 or higher, this is usually not a good time to be in the share market. Firstly, because these peaks always correspond with peaks in risk appetite and part of the market (so-called "smart money") will start pulling out in anticipation the trend will reverse for the worse. Secondly, because history shows the index usually doesn't hold on to such a high outcome and eventually a return closer to 50 will commence. That's when things are about to turn ugly.
This is the point when everyone with a positive bias towards the share market (the "Bulls") will tell you "the surveys are still positive", which, as said above, ignores an important factor in this story, and that is the underlying trend.
In simple terms: if the trend in these surveys is negative, the trend in the share market is negative too.
If we exclude the periods when PMI indices are merely trending sideways (it happens), we can easily distinguish four different periods: below 50, above 50, trend negative, trend positive.
Easy.
Time for a third element. This is the final one.
While the underlying trend in monthly PMIs tends to boost or weigh on equities' performance, it is the speed behind the trend that ultimately defines the severity of the impact on equities. In other words: if the slowdown in PMIs occurs at snail pace, it is more likely that equities lose a few percentage points here and there, but there's no obvious reason why they shouldn't continue rallying. If, however, the downtrend becomes significant, the result is always a share market in correction mode.
As one would instinctively guess, the worst time to be in the share market is when PMIs dive below 50 and they continue falling at a steep pace. In more recent times, this is what happened throughout 2008 and share markets really copped it during that time. The best time is when the index is below 50 but making its way back to neutral, which is what happened in 2009. For most investors, however, this is a rather scary time because a lot of the overall news is then still negative and all the PMI is indicating is that better times lie ahead.
It can thus be argued the best time is when the PMI surges from 50 to 60 and beyond. This is when corporate profits surge and investor sentiment tends to follow suit, thus share prices enjoy a jolly good time. We recently had such a period, it started in the second half of 2010 with a peak in February-March this year.
Since then, we have landed in that dreadful scenario number four: the PMI is trending lower from above 60 towards 50 and it matters not whether the end destination will be below 50, which would mark another recession. All that matters -so history shows- is that the trend is negative and whether the downtrend occurs at notable speed.
Equities always go through a hard time, in particular when the falls in PMIs become significant, as has happened since April.
Most of the research done into the relationship between PMI surveys and risk assets/equities centres around the US PMI, once upon a time known as the NAPM index. This is because the US has been the leading economy for most of the past century and we don't as yet have any track record for countries such as China, India and Brazil. But we do have economists at JP Morgan who put in the extra effort to combine the most important regional PMI surveys into one global index/survey.
The differences between the two indices are rather benign, which undermines statements made such as it's all the fault of the Americans, or of the Europeans, or because of the Japanese earthquake with nuclear scare. The world is going through a negative trend in monthly PMI outcomes and it shows up as a near universal downturn. Moreover, the speed in the decelerating trend has taken many experts and economists by surprise, which explains why share market weakness, and commodities weakness, and USD strength has equally surprised many experts.
Now for the key question: what lies ahead?
Here too, these monthly PMI surveys are very useful, because each survey tends to come with insights into near-term trends. For example, the ratio of new orders to inventory tends to lead future production levels by several months. Also, the index of finished goods inventory tends to lead actual production levels in months to follow.
This is why so many economists and market strategists are convinced global equities will continue doing it tough for a while longer. They have simply taken guidance from the May PMI surveys across the globe (these PMIs were released in June).
All this also explains why 2011 looks so similar to 2010; it's a scenario written by the monthly PMIs.
The key message in all of this is that none of this means the world is once again sliding towards an economic abyss. It doesn't exclude it either, by the way. Assuming all this ends with a stabilisation in PMIs at some point, somewhere near 50, the correction we have seen thus far in equity and commodity markets has been pretty much in line with the usual script. In fact, it can be argued the decline in US equities looks a bit light given the steep fall in the US PMI in May. But maybe that can be explained by the fact the downtrend for the global PMI was not half as bad, though bad nevertheless.
Let there be no misunderstanding: JPMorgan's global manufacturing PMI fell by 2.1pts to 52.9 in May and every component of the survey contributed to the drop (my emphasis). As a true indicator of the weakness around the world, only the Japanese and Brazilian indices rose on the prior month, while thirteen of the twenty-three PMIs fell by at least 2 points (which is a big fall month-on-month). Out of all these data, only three new orders sub-indices moved higher.
The most important piece of PMI analysis I have come across recently was conducted by analysts at UBS who believe that, on historical patterns, the true outperformance of defensive stocks over cyclicals is yet to come. UBS also found that when the PMI trends lower from 60 towards 50, this does not automatically mean share markets will put in a negative performance. It's just that, overall, performances tend to be rather modest (think low single digit returns).
Maybe the most important take-away conclusion from the UBS analysis is that, compared with cycle patterns that have occurred over the past 40 years, the current cycle's trends have so far proven to be quite "normal".
Forget about reading the newspaper or listening to headless chooks on television and the internet; investors are much better off paying attention to the monthly PMI surveys. That, simply, is a given.
For more background/information about the subject:
– Why A Global Peak Could Be Near (March 10, 2010)
– Market Relativities (May 17, 2010)
– US ISM Manufacturing Index: The Charts (May 19, 2010)
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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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