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The Institute for Supply Management's non-manufacturing index is telling us that a change is afoot. The stock market hasn't caught on. Yet.
The ISM's index, which indicates the pace of service-sector activity in the U.S. economy, slipped to 52.2 for June, its lowest level in more than three years. While any reading above 50 still indicates growth, the index indicates that the pace of growth has been in steady decline; it has fallen in three of the past four months, after hitting a one-year high of 56.0 in February.
Yet the stock market has been somewhere between dismissive and contemptuous toward this erosion in the services ISM. The S&P 500 was up slightly in mid-afternoon trading Monday; over the course of the services ISM's four-month slide, the S&P 500 is up almost 8 per cent.
For many market economists and strategists, the ISM service-sector reading takes a back seat to the more closely watched ISM manufacturing index. They believe the manufacturing ISM (which also came out this week, showing a modest uptick to 50.9) is the better indicator for stocks and the economy; it implies demand for tradeable goods, for raw materials, for concrete things that we can wrap our hands and heads around, that simply feel more like meaningful economic activity.
But the service sector actually makes up roughly two-thirds of U.S. economic activity; market watchers ignore it at their peril. What's more, stocks have tracked the services ISM quite closely (see chart) throughout the recession and recovery – in many cases, more closely than the manufacturing ISM. When the market and the services ISM have diverged, as they are now, it is typically the ISM index giving an early signal of a turning point – a signal the stock market eventually follows.
The accompanying chart shows the comparison between the ISM non-manufacturing index and the S&P 500 since the middle of 2007. It shows that at several key turning points for the stock market, the services ISM has given off a sign of a sea change before the U.S. stock market caught wind. The services ISM took a sharp dip below 50 (indicative of a contraction in the service-sector economy) in January, 2008, which only in hindsight was recognized as the approximate start of the U.S. recession; it spiked higher in January, 2009, two months ahead of the market's bottom; it peaked in February, 2011, turning downward a couple of months ahead of the stock market's biggest correction since the recovery began.
In the past six years, there hasn't been a single meaningful move in the ISM non-manufacturing index that stocks didn't follow, sooner or later. Until now. So far.
There's little doubt that the stock market is obsessed with monetary stimulus in general and quantitative easing (QE) specifically, and has been neglecting fundamental macroeconomic signals in the process. That's not going to work over the longer term. The slowing pace of U.S. service-sector growth will eventually catch up to stocks – and the history of the past few years suggest a market correction is on the horizon.
David Parkinson is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow him on Twitter at @parkinsonglobe .
David Parkinson