Chart Advisor: What Does the Market Think of the ISM?

By Rich Excell, CFA, CMT

1/ What Does the Market Think of the ISM?

2/ Jobs will be Important This Week

3/ This Tried-and-True Measure is Flashing a Yellow Signal

4/ The Most Important Measure of Them

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1/ What Does the Market Think of the ISM?

Yesterday we looked at intermarket analysis. We wanted to understand how traders and investors can find information in other markets that can help inform their opinions. For me, I like to use this to avoid Confirmation Bias. This bias is a behavioral bias in finance whereby traders and investors only look for information that confirms their view. How true is that on social media today?

_{Source: StayVigilant.Substack.com, Bloomberg}

In order to avoid this, I look to other markets to see the interpretation of events. For example, I pay close attention to economic data. There is always the debate between the hard data (e.g. GDP) and soft data (e.g. ISM). We get the ISM data today which is what I prefer because it coincides with the financial markets and it is not subject to the revisions that the hard data is. However, the ISM has told us all year that the economy is not as good as the GDP is telling us. Thus, I look to the commodity markets, especially the metals. Industrial metals are most impacted by the strength or weakness in the economy. I look at copper – which is affected by plumbing, electricity, the grid, EVs – and divide it by the gold price to take the FX effects out. When I look at this ratio, I see that the commodity markets agree that the economy may not be as robust as the GDP data tell us.

2/ Jobs will be Important This Week

This week we will also get the non-farms payroll data on Friday. On jobs day, I always feel the story is within the story and not the headline data itself, which will be revised in the next three months, is subject to seasonal birth/death, and has a standard error larger than the headline itself.

_{Source: StayVigilant.Substack.com, Bloomberg}

A component within the data that has drawn considerable attention of late is the 3-month moving average of the unemployment rate. Federal Reserve researchers created something called the Sahm Rule. It states that when the 3-month moving average of unemployment moves more than 0.50 from the lows, we have a recession. I have created a visual of that Rule in the chart above.

You can see that it is at 0.43 right now and a move higher by 0.2 or more could put us in that area of 0.50. Look back to the last 50 years of data. The recessions are the red shaded areas. The horizontal line is at 0.50. When the measure hits 0.50, we ALWAYS have a recession with no exceptions. Does that put extra importance on the number this Friday?

3/ This Tried-and-True Measure is Flashing a Yellow Signal

Another metric that has a very good track record at forecasting the economy is the yield curve. The yield curve has gotten negative headlines lately because it inverted last year and yet we have not seen a recession yet. In fact, it inverted by the most we have seen since the 1980s, yet no recession.

_{Source: StayVigilant.Substack.com, Bloomberg}

The reality, however, is it isn’t the inversion that predicts the recession, it is when the yield curve re-steepens past zero. You see, when it inverts, there have been recessions, but the lag time is long and variable. When it re-steepens we have a recession almost immediately.

In the past few weeks, the curve has been steepening from -100 to -22. It has still not moved above 0, but it is getting closer. Is this another signal telling us to be careful? Could the yield curve redeem its image?

4/ The Most Important Measure of Them 

When it all comes down to it, all this talk of the economy has to impact markets, or we only care a little bit i.e. if our own job is affected. The main thrust by which it impacts markets is through the 10-year yield itself. This yield is the price upon which all other assets are priced: other sovereign debt, corporate credit, equity multiples and even commodity curves. It is the golden rule itself.

_{Source: StayVigilant.Substack.com, Bloomberg}

You can see that the 10-year yield has been moving lower, from a high last year of 5%, to a high this year of 4.6% and current level of 4.17%. This is a series of lower highs, even if we have yet to see a series of lower lows. The price action is forming a pennant pattern that looks to be at risk of breaking on the downside. As it has already moved below shorter-term moving averages like the 1- and 3-month, I am watching closely to see if it moves down to the 3.43% 150-day moving average that has defined the trend in the last 5 years.

Even if the economic data appears to be weak, this could be good news for bond markets, as lower yields mean higher prices. It ultimately would lead to the self-correcting mechanism of capitalism as well, with lower 10-year yields meaning lower mortgage rates for homeowners, lower cost to expand for corporations, and cheaper source of leverage for traders. We have an important week for data, make sure you are looking for as many indicators as possible to avoid the Confirmation Bias.

Stay Vigilant!

About This Week’s Author

Rich Excell, CFA, CMT is a 30-year hedge fund and proprietary trading veteran who has lived and worked in Asia and Europe in addition to the United States. He has run investment businesses spanning equities, fixed income, commodities and foreign exchange. Rich is now a Clinical Assistant Professor of Finance at the Gies College of Business, University of Illinois, Urbana-Champaign. He also is the host of the Investment Exchange Forum and Macro Matters podcasts for the CFA Society Chicago and writes a bi-weekly options trading blog ‘Excell with Options’ for the CME Group. Finally, he writes a weekly Substack blog called ‘Stay Vigilant’ which aims to demystifinance for the average investor. 

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Originally posted on July 31st, 2024