Connecting the dots

What we've got here is failure to communicate. — Strother Martin (as Captain) in Cool Hand Luke

With the shutdown of schools as a result of the containment efforts surrounding COVID-19, my wife and I, along with most parents, have added teacher to our resumes. As part of the daily schoolwork, my five-year-old daughter is doing some connect-the-dots work, where you follow the numbers and connect the dots to create a picture.

I bring this up as it’s a very simple explanation of what our team does. We take many different data points and pieces of information to create a picture of what we believe the future of the equity and fixed income markets might look like.

One of those data points that we pay specific attention to is the manufacturing Purchasing Managers’ Index (PMI). This index is created based on the results of a monthly survey to gauge the health of the manufacturing sector of various countries around the world. The survey is scored with a baseline of 50, meaning that a number above 50 indicates expansion and below 50 indicates contraction. This index gives us valuable insight into the health of the economy and the likely direction of corporate earnings.

While there are different companies that produce similar indices, our team looks at two: IHS Markit and the Institute for Supply Management (ISM). Markit produces PMI indices for many countries around the world, whereas ISM is specific to the United States. We’ve seen a fairly strong relationship between the monthly ISM and year-over-year earnings growth for the S&P 500, advanced six months, going back to 1955. To put it simply, the current PMI data gives us a good indication of where the S&P 500 earnings growth is likely to trend six months from now.

The result for the month of March was 49.1, which we believe didn’t fully reflect the impact from COVID-19. The April data was just released, and the survey result was 41.5, the lowest level since the financial crisis. A figure of 45 is typically indicative of a recession. The current level of PMI would suggest that earnings growth could fall by 20–30% over the next six months. Given current valuation, we don’t believe that the market is fully reacting to this potential downside risk.

Although this decline was quite sharp, it’s actually worse underneath the surface. The PMI is a composite of five different components on an equally weighted basis: new orders (seasonally adjusted), production (seasonally adjusted), employment (seasonally adjusted), supplier deliveries (seasonally adjusted), and inventories. One of these sub-indices, supplier deliveries, is inverse to the others, meaning that a number above 50 indicates that deliveries were slower than normal, which is typical as the economy improves and customer demand increases. However, the high index reading in April was primarily a product of coronavirus-related supply problems, not increased demand. In this context, the high reading for supplier deliveries should be viewed as a negative rather than a positive. If we remove this abnormality from the calculation, and only use the other four sub-indices, the PMI would be a dismal 32.9, suggesting potentially a steeper decline in earnings over the next six months.

While the current forward earnings estimate of the S&P 500 Index for fiscal 2020 would suggest a decline of only 15% this year, the PMI would imply that’s overly optimistic and not a true reflection of the negative impact that the shutdown will have on corporate earnings.

When we connect the dots on this picture, we seem to have a much different result. While we believe there are opportunities at a company-specific level, we fear that the overall market has moved ahead of the fundamentals. In this environment, we remind investors that asset allocation is a moving target and we need to keep moving with it.