Is the ISM Manufacturing Report Flashing a Warning?

U.S. manufacturing
U.S. manufacturing

Investors cheered Monday's report from the Institute for Supply Management (ISM) that its U.S. manufacturing index fell in July to a better-than-expected 55.5. It was the 12th straight reading above 50, which indicates that the sector is growing.

However, there's more to the economy than manufacturing alone. According to Bureau of Economic Analysis data, manufacturing accounts for around 11% of U.S. gross domestic product (GDP), while the service sector is responsible for more than 80%.

In fact, an analysis of the relationship between the ISM's twin gauges of manufacturing and services-related activity suggests that the outlook may not be as rosy as many believe.

Based on past history, whenever the manufacturing-services ratio (MSR) has spiked above 1.01 or so and then shifted into reverse -- as it has done recently -- it has preceded a notable downturn in the year-on-year rate of change of real (inflation-adjusted) GDP by one to six months.

Admittedly, the history of this particular relationship is relatively short (the ISM's services gauge came into existence only in 1997), and as is generally the case with trends that appear to be linked, correlation does not necessarily imply causation.

Regardless, the less-than-upbeat message of the MSR -- which, as it happens, peaked in January -- dovetails with other recent data on employment, housing and consumer spending that suggest the already-sluggish U.S. economic recovery is faltering.

Another reason, perhaps, for investors to think twice before getting too bulled up about the near-term outlook.