If you are like me, you are probably a bit taken aback by the recent strength in ISM data. The data suggests the economy is performing at a healthy pace and to this point strongly argues against recession or economic woes. With earnings season around the corner, it might be worth examining the relationship between the ISM manufacturing production and ISM non-manufacturing activity indices and year over year operating earnings per share for the S&P 500. It seems like the strength in the ISM data could filter into strong Q3 profit growth. Let’s take a look.
The ISM headline data usually makes the news, but below the surface the production index from the manufacturing report and the activity index from the non-manufacturing report are clearer reads on economic output. They provide a look at sentiment relative to what is going on with output and can be analogous to industrial production. Further, the manufacturing sector is a smaller segment of the economy than the service sector so to get a realistic view of the economy the indices must be weighted to come up with a composite which is reflective of the economy. There is no a perfect mix, but I, arguably, tend to use a 20% manufacturing to 80% service mix. This probably over weights the impact of manufacturing sector, but with the energy revolution and shifts in economic activity the percentages likely change over time.
The production and activity indices were strong in the third quarter. The three month average of the indices was 60.0 on a 20/80% mix. This is the highest reading since 2011. For the month of September, the reading was 56.6 down from a high of 62.2 in August. The non-manufacturing sector dragged the composite index lower falling from 62.2 to 55.1, while the manufacturing production index rose 0.2 to 62.6.
There is a solid relationship between the ISM production/activity mix and the year over year change in earnings per share for the S&P 500. A downtrend (uptrend) in the ISM production/activity tends to occur with contracting (rising profit growth) profit growth. The strong readings in the ISM indices tend to argue for a recovery or strength in profit growth. The chart displays the relationship. The whip saw from the Great Recession on earnings growth was eliminated and accounts for the gaps in the EPS growth series.
The chart tends to argue favorable Q3 earnings growth. The ISM production/activity mix was up sharply and should feed into acceleration in profit growth.
Getting more quantitative:
Taking a look at the relationship in a more direct manor, the next chart displays the scatter plot between the two series. The x-axis holds the ISM data, while the y-axis represents EPS growth. The ISM mix explains about 63% of the movement in year over year S&P 500 earnings per share. The relationship argues for EPS growth at 19% in Q3 which is well above current estimates. However, the range of values around the average relationship is between about 10% and 25%. The scatter chart illustrates the relationship with values around the dashed box putting a spotlight on the 60 ISM level.
As Zacks Research Director Sheraz Mian noted in his recent report “Q3 Earnings Season Gets Underway”, the first 21 companies in the S&P 500 reporting profits displayed EPS growth of 8.8% y/y. Revenues were up 7.4% y/y. The ISM reports seem to be supportive to the early pace of profit growth and may even argue for more strength going foward.
Markets are forward looking and the political gridlock in Washington is a headwind to higher stock prices and economic growth, but at face value the ISM reports argue for solid Q3 earnings results. This should be at least one favorable dynamic for the equity market. From this analysis, it is easy to see why the markets react to ISM data each month.