Chart of the Day illustrates the principle of a market indicator generating a possible sell signal long in advance of the actual market move.
The purpose of adjusting the inputs of the PMI is to better emphasize those components that correlate with the financial markets. Today’s chart illustrates how the COTD PMI has tended to peak 12 months before S&P 500 earnings.The supporting logic for this phenomenon is that a surging economy puts upward pressure on inflation and interest rates, which can then negatively impact corporate earnings. Today’s chart illustrates that the COTD PMI peaked 12 months ago.
Note: The ISM PMI is a composite index based on the seasonally adjusted diffusion indexes of five major indicators including: new orders, production, employment, supplier deliveries, and inventory levels.
The ISM’s Purchasing Managers Index (PMI) has a tendency to peak a year
before the SPX’s earnings do. Earnings also peak considerably before
the market does; Creating a tradable signal requires additional input.
Recall that the Nasdaq 100 earnings peaked in 1998 — well before the
crash. Perhaps behavior in bubbles is skewed enough that the ultimate
top was delayed a year or two.
But its yet another example of the challenge of trading off of pure economic data — while correlated over long periods, the timing aspect invariably requires a secondary indicator to have a hope of generating a timely trading signal. Confirmation from Sentiment indicators (Put/call ratio, Arms Index, Bull/Bear ratio) and/or Market internals (Advance decline, Up/down volume, Hi/Los) is helpful.
An economic signal, combined with good Sentiment and Internal indicators, can generate a tradable signal — for both tops and bottoms.