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The economy has shown signs of an upswing in recent months.  The ISM non-manufacturing and ISM manufacturing surveys have displayed vibrant growth and shaped the outlook for improved economic conditions.  The activity index of the non-manufacturing index and the production index of the manufacturing index are both over 60.  A 62% non-manufacturing to 38% manufacturing mix of the indices was 62.3 in August up from 61.1 in July.  There have not been two back to back readings over 60 since March of 2011.  The ratios were calculated by taking the percent of GDP in Q2 2013 from the goods and services categories.

Given the strength of the ISM survey and rising expectations for economic growth, it might be worth looking at which market sectors are most positively correlated to the ISM survey.   Put another way, it might be interesting to know which sectors are most likely to rise (fall) when the ISM survey increases or (decreases). The table shows the correlation of the ISM mix level to the price of the respective Zacks Industry Sector and the correlation of the monthly percentage change in the respective Zacks Industry Sector and the ISM mix.

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Looking at level and prices:

Going back to the middle of 1999, the sector with the most positive correlation based on level (price against ISM reading) is the consumer discretionary sector followed by the financial, information technology, and the industrial sectors.  The results are on the surprising side, as one might think industrials would show more strength than consumer discretionary on an upswing in business sentiment/activity.  The utility sector was slightly negatively correlated – higher interest rates in the face of stronger growth may hurt this sector, although industrial activity should be positive for electricity and power demand.  There was limited correlation with energy.

Looking at monthly percentage change:

The monthly percentage change displays less correlation, but the numbers seem to drop highlighting a reduced relationship.  In this calculation, consumer discretionary continued to post the highest correlation, while industrials were the next strongest sector followed by the financial sector.  Telecom services and energy posted the lowest correlations, but each of the categories was positive.

Table conclusions:

The take away from the table seems to suggest that consumer discretionary stocks and the industrial sector are likely to trade well if the ISM is strong.  Financials would be in third place.

It may be hard to expect continued strength in the ISM given that the mix has been 60 or above just 21.0% of the time since the middle of 1999.  The market is probably a month or two away from seeing a setback in the ISM.

Looking ahead:

The graphic looks at the relationship between the ISM mix three months forward and the industrial, consumer discretionary and financial sectors.  The idea here is that current strength in the ISM could have a lasting impact on these sectors out three months.  

(click to enlarge)

The graphic shows the relationship.  Boxes in the graphic highlight strength in the ISM over 60. Here is a quick summary of results:

 In 1999/2000, the consumer discretionary and financial sectors seemed to struggle, but industrials displayed strength.

In 2002, the entire market seemed to set back – all three sectors fell.  The post 9/11 bounced faded due to accounting scandals – Worldcom and Enron and the enactment of Sarbanes-Oxley unnerved the market.  None of the sectors performed well.  There may have also been more draining of the stock market bubble.

In 2004, there seemed to be some upside follow through in finance and consumer discretionary, but a small correction in industrials.  The industrial sector did seem to power higher after a pause.

In 2007, consumer discretionary was leading lower, financials showed some strength before fading and industrials tried to outperform, but were pulled down.

In 2010, the strength in the ISM seemed to pull the indices higher off their relative lows.  There seemed to be some follow through strength into 2011.

In 2011, the dip in the ISM eventually led to a correction in all three of the sectors.  Note that the market had to deal with the EZ debt crisis.  In April Portugal could not finance itself and there was also the threat of a Greek exit from the EZ.   The stock market was influenced by sovereign credit issues and this also seemed to weaken the growth picture.

The relationship between the ISM and the stock market is not exact and it seems like some of the correlation between the consumer discretionary sector and the ISM is picked up more on the downdrafts than during times of strength.  However, my conclusion rests in the industrial sector having the best chance for performance.  The industrial sector seemed to hold in 1999/2000, 2007, and 2010, at least that is my read from the graphic.   

How to play:

If my read of the past relationship is close to correct, industrial sector ETFs or individual industrial related shares may be the way to profit from the recent trend in the ISM.  The industrial sector SPDR (XLI - Free Report) and Dynamic Industrials Sector Portfolio (PRN - Free Report) are two ETFs worth a look.  The XLI is market cap weighed and has about an 11% exposure to GE.  This PRN uses factors like price momentum, earnings momentum, and value in its weightings which are more balanced.  Both have broken out to new highs and are reflecting the idea of global economic expansion.

A second way to play may rest in individual equities.  In the industrial product space, Gorman Rupp and Rexnord Corporation  (RXN - Free Report) are Zacks Rank #1 companies (Strong Buy).  GRC has run with the market, and looks like a momentum play.  It makes and sells pumps and related equipment, while RXN is involved with process & motion control products and water management. It has traded sideways recently and not been a major participant in this year’s bull market.  A third name is Enpro Industries (NPO - Free Report) .  NPO is a  Zacks Rank #2 (Buy) and is just below its 52 week high at $62.05.  A push over $62.00 could spark technical interest.  NPO makes sealing products, bearings, compressor systems and other engineered products.  All three stocks are seeing favorable earnings revisions estimates which suggest they are able to leverage off the growth story.

Whether through an ETF or individual names, the industrial sector looks ripe to support the equity market in the coming months.

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