How Stocks Help Us Look Ahead

Since the beginning of the year, stock prices have made new all-time highs and then moved sideways, while prospects for economic growth have continued to rise. Some investors were puzzled by the market’s rapid rise last year, during the depths of the pandemic, and now wonder why, after a meteoric rise, stock-price appreciation has paused as the economy continues to improve.

Stocks prices represent both investor sentiment regarding companies’ earnings prospects and the expected value of those earnings in the future. As a result, stocks are a leading indicator of future economic activity.

Let’s dig into some of what they seem to be indicating.

Manufacturing Past Peak?

Last week, the Institute of Supply Management (ISM) released its April purchasing managers’ index (PMI) report on manufacturing activity. This index reflects what corporate buyers in the manufacturing sector are seeing in activity levels across many industries. A level above 50 represents expansion in the manufacturing sector.

As you can see from the chart below, the index registered 60.7%, well above 50%. However, that level represents a dip from the previous month’s high of 64.7%.

This month-over-month decline could represent the economy’s biggest opening problem. One of the survey respondents said, “In 35 years, I’ve never seen everything like these extended lead times and rising prices….” That purchasing manager’s sentiment is echoed many times over across most industries.

The combination of a near-complete shutdown of global manufacturing last year, plus the rapid rise in demand as developed economies like the U.S. and Europe reopen, has created unprecedented bottlenecks in supplies of copper, steel and other metals, semi-conductor chips, and many other component parts of the finished goods we consume.

These bottlenecks are pushing prices of certain goods higher, causing inflation. The argument that inflation is "transitory" (as made by Fed Chairman Jerome Powell) reflects an expectation that prices will return to normal levels once pinch points in the supply chain are worked through.

The chart below shows what lumber prices (dollars per 1,000 board feet) have done in the last several months. You can see the rapid rise—and now subsequent decline as supplies improve.

Stocks Lead the Economy

What does supply chain normalization mean for stock prices? Because stocks are a leading indicator, they anticipate improvement in economic activity. Purchasing managers’ surveys, like the PMI index, are a great way to measure activity. When we look at the correlation between the two, we can see how this plays out. The chart below provides a long-term historical view of this relationship.

The chart takes the last 70+ years of PMI index measurements and breaks them down into deciles, from the lowest observed measurements to the highest. Above each decile, the average return for the S&P 500 Index is shown during those periods. You can see that the lowest activity levels, as measured by PMI, show some of the highest stock returns. Stock investors anticipate a recovery in activity and push prices higher well ahead of the actual improvement seen in PMI measures and the economy.

This helps us understand the stock-price movement of the last 12 months. Last April, during the beginning of the pandemic, the PMI index bottomed just above 40, representing a contraction in activity. At that time, stock investors began to see that as an indication that the economy’s growth was at its nadir. Stock prices rose, with market participation first coming from companies benefitting from people staying home. As vaccine news improved, market breadth expanded and many more companies participated in the rally.

Glance back at the first chart above. You can see that the PMI value rose steadily throughout 2020 and into March of this year. If we look at our experience with stock returns, they seem to track, closely, the experience we’ve seen in history.

What’s Next?

Our expectations for the economic recovery have improved steadily since last November. However, as we mentioned earlier, the challenges being experienced from a supply-chain perspective are broad enough that they may limit the accelerated growth rate in economic activity.

Also, we know that growth will return to “normal.” That implies a level closer to 3% than this year’s 7% or 8%. As a result, it isn’t likely that we will continue to see stock price appreciation of the kind we’ve experienced in the last 12 months.

Still, with interest rates low (a 10-year Treasury yields just 1.58%), stocks may provide a better return than most other asset classes.

ABOUT THE AUTHOR

Brian Andrew

Chief Investment Officer | Johnson Financial Group

As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.