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The Global View: What does the ISM mean for US equities?
Jan. 3, 2012

Rise in ISM extends trend of improvement in US data Normally, a rising ISM would bode very well for US stocks Uncertainty, foreign weakness to continue keeping a lid on equities We prefer large-cap growth, US and global dividend strategies

The ISM manufacturing survey's December rise, to 53.9 from 52.7 the previous month, extends the recent run of encouraging US data. While not all of the numbers have looked good, two of the most historically reliable business-cycle indicators the ISM and jobless claims have been pointing in the right direction since November. Even the beleaguered housing sector has shown some signs of improvement in the past few months. US GDP growth may have topped 3% in the fourth quarter of 2011. Normally, the increase in the ISM manufacturing index three points in two months would bode well for US equities. As Chart 1 shows, since the late 1990s, the ISM has correlated fairly well with US stocks (represented here by the year-on-year percentage change in the level of the S&P 500). That makes sense: the ISM generally does a good job capturing swings in the economy's most cyclical sector, and by extension overall growth, which is what equity investors are primarily paying for. Based on this track record, the current level of the ISM looks consistent with a double-digit percentage increase in the S&P 500.

If we hone in on the right side of Chart 1, though, we can see that the relationship between these two variables appears to have broken down during the past year or two. What accounts for this divergence? Most likely, one technical factor and two fundamental forces explain the gap. On the technical side, elevated volatility amid persistently high economic and political uncertainty, particularly in the second half of last year, has discouraged investors from building and holding long positions. VIX has averaged 32.2 since August, not exactly a friendly environment for a buy-and-hold approach. Given this year's heavy political calendar and the extent of the problems facing euro area policymakers, volatility seems likely to remain a fact of life in 2012. More fundamentally, first, the ISM itself has not tracked underlying growth as accurately as usual. Chart 2 shows that the ISM surged in early 2011, just when the US economy was weakening significantly, then plunged around mid-year when growth was beginning its reacceleration. Analogous surveys elsewhere in the world have also struggled over the past couple of years. The various natural disasters and similar shocks so prevalent recently most obviously the Japanese earthquake and tsunami may be partly responsible. They have exercised outsize but narrow effects on a few sectors, while purchasing managers' indices are set up to capture broad-based swings. The ISM and similar foreign surveys may also have reflected extreme moves in business confidence that for whatever reason have not translated into changes in output. This unusual atmosphere might continue, though hopefully natural disasters won't characterize 2012 as they did last year. But given the ISM's excellent historical track record, it seems reasonable to expect that the survey will reconnect with near-term growth trends, as indeed seems to have happened in the past few months.

Second, the environment facing US companies has differed from the US economy itself, to an unusual degree. The global economy has displayed a striking lack of synchronization in the past year. Emerging economies boomed at the start of 2011 when the US was weak. Then, the euro area slid into recession around the start of 11Q4 and emerging economies slowed sharply in the second half of last year, just at the time that the US was finding its footing. Japan, meanwhile, has fluctuated somewhere

in between the US and Europe. Chart 3 illustrates this point with G-3 purchasing managers' indices. Investors realize that US firms are increasingly playing on a global field, with foreign sales now accounting for an estimated 30% of the total for S&P 500 companies. International exposure (and the benefit of a weaker dollar) supported US stocks in early 2011, when the local economy was weak, but has been a headwind more recently. In other words, in the past several months the ISM has not served as a very good shorthand representation of the atmosphere within which US companies have been operating. This situation, unfortunately, will likely continue at least to some extent, with limited prospects for a near-term revival in euro area growth especially.

Bearing these caveats in mind, what does the ISM tell us about US equities in 2012? First, we need a projection for ISM levels during the year. Chart 4 shows a rough-and-ready forecast based on three assumptions: first, as mentioned above, the ISM reconnects with the US economy; second, US growth slows marginally from its recent clip but remains above 2%; third, manufacturing underperforms slightly as business investment cools and other sectors like residential construction and spending on services pick up. Under these circumstances, the ISM would likely finish 2012 a little below its December 2011 reading, but at a still decent 53-53.5 level.

Going back to Chart 1, and looking at a simple regression of the S&P 500 on the ISM from 1998 to 2010, we can back out an implied gain in US stocks by the end of 2012 in the 8-11% range. In level terms, given the 1258 closing level of the S&P 500 in 2011, that increase translates to 1358-1396. By historical standards, this result looks reasonable, representing as it does a basically "normal" year for US stocks against the backdrop of what is assumed to be fairly typical, slightly above-trend growth. In today's world, though, this outcome likely represents not a baseline expectation but a goodcase scenario, given prevailing volatility and current weakness elsewhere in the global economy. US equities have made a good start to the year today, rising nearly 1.7% at mid-day and poking their head above the top of their recent trading range. Completing the annual gain implied by the forecast ISM path, though, will likely require not only that the US economy holds up in the face of fiscal tightening, the presidential election, and financial headwinds, but also that overall market volatility diminishes, the euro area economy touches bottom, and EM growth reaccelerates. Given the uncertainty about overall market conditions, we want to focus on a few equity strategies in particular this year. As highlighted in our "Top Investment Questions for 2012," released Monday, we prefer US large-cap growth and both US and global dividend equity strategies. We also see a role for natural resource equities, in part as a hedge against commodity-related inflation and to reflect structural emerging-market commodity demand. Michael Hood Markets Strategist, J.P. Morgan Asset Management 212-648-1564 Rebecca Patterson Chief Markets Strategist, J.P. Morgan Asset Management 212-464-2093 http://www.jpmorgan.com/institutional/marketviews

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