“Less bad” PMI good for equity returns

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The ISM manufacturing Purchasing Managers Index (PMI) for the US last month recorded a further increase – from 40.1 in April to 42.8 in May. Although the Index improved, the number below 50 still represents a contracting manufacturing sector, but at a markedly slower pace.

“Overall, the gradual improvement in the ISM index over the past several months is consistent with our forecast for a moderation in the decline in manufacturing industrial production and for the economy to resume growing in the second half,” said Moody’s Economy.com

ism-020609

Source: Moody’s Economy.com

As far as the relationship between the manufacturing PMI and stock market returns is concerned, Goldman Sachs found that “the market tends to ‘front load’ future returns in such a way that the strongest part of the typical bull market is during the phase when economic and profit growth is still negative, but the deterioration is slowing.”

The graph below shows that the period when the PMI goes from its bottom turning point towards 50 – a phase when manufacturing is still contracting – in general provides higher returns than the phase in which the economy starts expanding again.

ism-020609b

Source: Goldman Sachs – Strategy Matters, May 15, 2009.

The stock market rally might be a case of “too much too soon”, but the strong returns in the midst of the “less” bad manufacturing data are certainly consistent with the historical pattern.

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