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ISM: A Contrarian Indicator?

Published 09/02/2014, 04:14 PM

In 2011 -- the last time that the Institute for Supply Management's ISM indicator hit levels it registered Tuesday morning -- I remember reading that the index had some contrarian tendencies at the extremes. In essence, stocks tend to rise after extremely weak readings and tend to fall after extremely strong readings.

ISM And The S&P 500

Below is a chart of how the S&P 500 has fared in the year after extreme ISM readings.  When the index crossed above 59 from a lower level, the S&P 500 tended to rise over the next 12 months, but at a relatively slow pace -- just 1.6%.  Ten times out of 28, the index declined.  On the other hand, the index has tended to rise significantly when the ISM index crossed below 41.  Indeed, the index has risen 9 out of 10 the times that has happened and risen by an average of 15.8% over the next year.

If you subscribe to a contrarian market view, those patterns may make sense.  The ISM survey is an indicator of sentiment because it asks operators how they feel about business.  When the index is extremely high, it may indicate that people are overly optimistic.  When the index is extremely low, it may indicate that people are overly pessimistic.

Extreme sentiment is often a leading indicator that something is about to change.

The ISM And The S&P 500

Source: FRED, Yahoo, Avondale

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