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Why the S&P has likely topped for the year …

A cursory read of the financial media suggests to me that the global equity market weakness has not done much to shake the bullish consensus.

My view, for what it’s worth is that the S&P has likely seen its top for the year. Even if I’m wrong, I don’t see the Jan high in the S&P being exceeded by more than a few points.

Why do I say that? In a nutshell, because the economy is in the late cycle and US growth has peaked. Every major turning point in the S&P since WW2 has been associated with peaking growth in the late cycle. As a rough guide, the late cycle, that is to say the late phase of the economic expansion, starts when the US jobless rate falls below 5%. The jobless rate fell convincingly below 5% in late 2016.

The US ISM index is widely considered the best monthly proxy for US growth. Peak readings generally occur when the index hits a reading of 58 or higher.

The following chart shows that the ISM Index hit  60.8 in February. This is a super strong reading. In fact, this is only the 4th episode since 1980 that the ISM has exceeded 60. Looking at the chart, history suggests that the ISM will recede from here. In other words, history suggests growth is at or very near a peak.

The ISM Index suggests US growth has peaked

Source: Bloomberg

We can be a little more precise. Since 1975 the ISM index has always fallen within 6 to 12 months of a reading above 60 with an average decline of 10 index points. The smallest ever decline was 3.9 points. If the Fed was tightening prior to the 60-plus reading, the average decline was 13.4 points and the smallest decline was 7.5 points. In 68% of these episodes, the ISM Index was under 50 within 18 months of the 60-plus reading. In slightly under half of these episodes, the US economy was in recession.

In summary, I have enormous confidence that the ISM will be low by end-2018, possibly quite a bit lower.

Okay, so let’s now investigate how the S&P performs in the late cycle when the ISM Index is falling. The following table its shows the average S&P return (annualized)  in quarters when the ISM was going down.  The table considers 4 rates of decline from modest (less than 1 point) to severe (more than 4 points).

The table splits the historical return into two regimes: a late cycle regime in which the US jobless rate was below 5%, and a regime covering all other periods of the economic cycle.

Hands up if you think this table is interesting?

Yep! The impact of a declining ISM Index depends crucially on whether the economy is late cycle or not. The distinction is profound.

Outside of the late cycle, slowing economic growth is no big deal – the S&P is insensitive to all but the severe declines in the ISM Index.

But when the economy is late cycle and the ISM Index starts to fall, you’d better call an ambulance. When the ISM Index declines in the late cycle the average annualized return of the S&P is -24%. Equity weakness worsens the harder the ISM index falls but so long as there is some decline, the S&P is likely to decline. I haven’t shown the effects of valuation but the tendency is the same whether the S&P is cheap or expensive.

Near term, US economic momentum remains strong. The US leading indexes are rising. Hence, growth might remain elevated for a while yet.  But, as we move into the second half, I’m very sure the ISM Index will be falling and the S&P will be sliding along with it.

So, next time you hear an expert proffering a view on the S&P be sure to ask whether they think we are in the late cycle or not.


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