The ISM new orders to prices paid spread suggests caution

Key points:

• The ISM new orders index contracted by a meaningful amount in March
• At the same time, the ISM prices paid index surged to one of the highest levels in history
• The spread between the two ISM indexes contracted by over 33%
• The S&P 500 shows flat to negative returns after similar contractions in the ISM spread

The ISM new orders to prices paid spread as a leading indicator

The Institute for Supply Management releases its monthly survey on manufacturing on the first business day of each month. While the manufacturing composite index gets the headlines, I like to examine the relationship between two individual components. The spread between new orders and prices paid is an excellent measure for identifying a bullish or bearish macroeconomic backdrop for the stock market. A significantly negative spread, like today, suggests an unfavorable environment as inflation impacts future growth.

Let's assess the stock outlook when the spread between the new orders and the prices paid indexes contract by -25% or more. At the same time, the S&P 500 must still be within 15% of its recent high. I will use a reset cross above -10% to screen out repeat signals.

The spread has fallen to the lowest level since 2008. Before that contraction, one has to go back to 1980 to find a similar comparison.

Similar contractions in the ISM spread suggest a cautious outlook

This indicator generated a signal 13 other times over the past 72 years. After the others, S&P 500 future returns, win rates, and risk/reward profiles were unfavorable across medium and long-term time frames. The previous signal shows healthy gains. However, we need to remember the Fed was conducting QE. I would also note that the Fed reversed from a tightening to an easing cycle in 1995.

I adjusted the signal dates to reflect the first business day of each month. i.e., the release day.

Sectors and industry group performance after signals

The sector and industry group outlook suggests a cautionary stance for the consumer discretionary sector as returns are negative across all time frames. Energy looks favorable on a relative basis.

Due to data limitations, returns reflect signals since 1966.

Consumer discretionary sub-industry group performance after signals

The outlook for the consumer discretionary sector looks highly unfavorable. As was the case with my homebuilding note on Monday, I would avoid housing-related stocks.   

What happens to the Macro Index Model after signals

Applying the signal dates to the SentimenTrader Macro Index Model suggests the index will likely fall below the favorable 70% level in the coming months. 

What the research tells us...

When the ISM new orders to prices paid spread contracts by 25% or more, inflationary pressures impact future growth, which results in a challenging environment for stocks. Similar setups to what we're seeing now have preceded flat to weak returns for the S&P 500 on a medium and long-term basis. A review of sectors, industries, and sub-industry groups suggests opportunities outside the consumer discretionary sector may be more favorable. We should be mindful that the economy could slow in the coming months. I would keep an eye on the Macro Index Model.