The latest ISM Manufacturing report was once again very strong. But a look at the underlying data shows what might be a potential red flag. I know it’s not fashionable to discuss the risks in the market right now, but this is a fairly unusual event so it’s worth highlighting. Below is the ISM New Orders:Inventories ratio. This ratio has a fairly good track record of consistent negative readings prior to economic downturns. The most notable instances were 1973, 1979, 1991, 2001 and 2008.
In September the ratio hit -4.5 before bouncing back sharply to +5 in October. This month’s negative reading of -0.1 is nothing to panic about, but the trend is a clear deterioration since late 2009. What’s unusual about the most recent negative reading is its high level (56.7:56.6). The ratio has tended to go negative in the 40’s level. But the most recent negative readings are in the high 50’s – undoubtedly strong numbers. So, I went back in time to review if this had ever occurred before. The last time we saw such a rare occurrence was in the 1970’s. Prior to the 1973 recession and again prior to the 1979 recession we saw very strong ISM readings with the ratio going negative. If you know anyone who lived through those recessions they’ll tell you how brutal they both were and many people who lived through the 70’s will tell you that it felt like one big long rolling recession (sound familiar?).
Now, this is clearly not something to panic about just yet. The economic data has clearly been on the strong side and there is clear upside momentum, however, a persistent negative trend in this data in the coming months would be a sure sign that the economic “recovery” is waning and that our 1980’s moment (a painful clearing of past excesses) might be in the not so distant future.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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