The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- This Friday, April 1, the most important economic data in a month will be released and could turn unwary investors into April Fools. While all eyes will be focused on the employment report to see if the U.S. economy can string together two consecutive months of healthy job gains, we will be intensely focused on the release of the Institute for Supply Management Purchasing Managers Index (ISM) at 10am ET that day.
The ISM is one of the best leading indicators for the economy and markets. The Institute for Supply Management is a group that represents purchasing managers at U.S. corporations. They survey them each month and publish the results in the form of an index. Purchasing managers are at the front of the line when it comes to activity in manufacturing. Manufacturing companies need supplies to produce products and purchasing managers order these supplies. When demand starts to pick up for manufactured goods, these managers need to order more supplies. Conversely, when demand pulls back, they respond by trimming their orders.
Although manufacturing businesses make up only about 40% of S&P 500 company earnings, demand for manufactured goods has been a timely barometer of business activity of all types. This index is published at the beginning of each month offering one of the earliest signals as to how the economy and outlook for business is faring each month.
The long history of the ISM shows us how effective it has been in signaling each recession and recovery. While the ISM has given a consistent signal when the recession is ending, it has also signaled when the recovery momentum peaks and the economy begins to transition to a new stage. Looking back at the ISM over the past 35 years we can see that there have been a number of peaks and troughs that led the direction of economic and profit growth. The index has typically troughed around 30-40 and peaked around 60.
On Friday, April 1, the ISM will be reported for the month of March and is expected to decline to 61 from the February reading of 61.4. However, a key question for investors is: has it peaked? If so, stock market performance is likely to be modest and volatile going forward.
The S&P 500 has tended to perform well during the year leading up to the peak in the ISM. Over the past 35 years, the S&P 500 was up 18%, on average, in the 12 months prior to the peak in the ISM. However, once reaching the peak, returns were flat and volatile. Over the six months following the peak, stocks were up only 1%, on average. It is interesting to note that the S&P 500 was up and very close to average 17% in the 12 months before the February 2011 ISM was released on March 1, 2011. Since the release of that February 2011 ISM Index, the S&P 500 is down about -1% suggesting a weak start to what could be a soft period for stock market returns.
How closely the performance of the stock market and the ISM track each other can best be seen in the nearby chart (Chart 2). With momentum in the ISM at or near a peak, stock market performance is likely to soften on a year-over-year basis. Consistent with this relationship between the ISM and the S&P 500, we adhere to our forecast of a high single-digit gain for the S&P 500 in 2011.
The LPL Financial Current Conditions Index (CCI) appears to be confirming a peak in economic momentum as the economy transitions from a rapid recovery to a slower pace of sustainable growth. The CCI has receded from highs and the growth momentum in the index has stalled. With leading indicators, such as the ISM, at or near a peak, stock market price momentum may begin to fade.
It would be (April) foolish to expect the powerful pace gains over the past two years, as the S&P 500 nearly doubled from the low of March 2009, to continue. While stocks should be considered as a component of a diversified portfolio, other asset classes such as high-yield bonds and commodities asset classes may offer better prospects in the near future.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.