How I Understand and Forecast Equity Market Indices Part 1 - Importance of the PMI

Almost two months into my internship at Masterlink Securities, I want to consolidate on the things I have learnt throughout this rewarding experience. I especially enjoyed my time in the macroeconomics research team, where I learnt the usefulness of tracking different economic indicators to gauge market sentiment and help forecast market movements. I will summarise how the macroeconomics team thinks about equity markets and the indicators we look at. 

3 Main Drivers of Equity Markets

3 Main Drivers Economic Fundamentals, Monetary Conditions, and Pricing

On a very coarse level, the equity market is most often influenced by economic fundamentals and monetary conditions. The most significant drivers change all the time as macroeconomic events occur, so it is important to keep a wide perspective and understand the reasons behind these relationships. 

Next, I will explain the indicators I look at when trying to understand and forecast the market.

Economic Fundamentals Indicators

Institute of Supply Chain Management (ISM)’s Purchasing Managers’ Index (PMI)

The ISM PMI is arguably one of the most important indicators as it not only often leads the economic growth figures and equity market returns, but it also has meaningful relationships with other economic metrics such as CPI inflation, bond yields, and the US dollar. It is calculated by asking purchasing and supply executives across the United States to rate their level of business activity in several areas, including new orders, production, employment, supplier deliveries, and inventories. The PMI is then calculated using a weighted average of these responses, with a score above 50 indicating expansion in the manufacturing sector and a score below 50 indicating contraction. It is a good representation of the business cycle.

Exhibit 1: ISM PMI and US Nominal GDP YoY Growth: ISM is a good representation of the business cycle.

ISM and equities (S&P 500)

Exhibit 2: ISM Index (yellow) and S&P 500 (white) over the last 5 years: Positive correlation between ISM and equities

The ISM is usually correlated with stock market returns as a company’s earnings are correlated with its manufacturing activity; earnings can only grow sustainably if there is high demand for products. The components of the ISM, such as new orders, production, employment, and supplier deliveries, are good indicators that companies are facing increasing demand.

However, this relationship often changes as the monetary environment shifts. For instance, the relationship turned negative in 2019 when yields fell (purple line). The expectation of easier monetary conditions going forward represented by falling yields was able to lift equity markets against the backdrop of worsening economic fundamentals (PMI). The fed funds rate indeed fell in the latter half of 2019.

Exhibit 3: 2019 Falling yields (purple) and Fed funds (green) lead equities to rally despite worsening ISM:  Sometimes changes in expected monetary conditions trump the trend of economic fundamentals.

The relationship between ISM and equities has broken down again since September 2022. Equities have gained while the ISM has fallen. Unlike 2019, it wasn’t the yields that saved the equity market; it was the excess savings amassed during the easy fiscal and monetary environments of 2020-2021 that kept the economy and labor market strong. Additionally, there were optimistic voices in the market forecasting a soft-landing characterized by rapidly falling inflation and rates. The market had difficulty forecasting inflation and rates, with some predicting a soft-landing, others forecasting a hard-landing; some calling inflation sticky while others saw it being tamed. This lack of consensus has resulted in back-and-forth revisions of rates and inflation forecasts, which has prevented the equity market from sliding.

Forecasters are typically slow to adjust to new inflation trends after turning points and tend to assume a swift return to numbers consistent with the Fed’s 2% target

ISM’s Relationship with Other Economic Figures

Exhibit 4: Negative relationship between USD (DXY) and ISM

ISM and the USD tends to move in opposite directions because USD, as a risk haven asset, tends to spike during times of economic crises when ISM tends to be low. The the US market is stable, US rates tend to be lowered exerting downward pressure on the dollar, another reason for the negative relationship.

Exhibit 5: Positive relationship between US 10 year yield and ISM

Yields and ISM tend to move in the same direction as better economic fundamentals allow Fed to tighten monetary policy in a steady and predictive way. Worsening conditions would call for rates to be eased. The exception to this relationship in since 2021 has been caused by persistently high inflation, which prevented the Fed to ease even as economic fundamentals deteriorated.

This concludes my discussion on the ISM, one of the key indicators of economic fundamentals. In my next post, I will discuss other metrics such as jobless claims, and Conference Board leading indicator that also gives insights into economic momentum.