Update: The ISM Manufacturing Report was positive for the month of January.

There is no way to know how long this recession will last, but there is at least one indicator which could give us a clue about when the stock market will bottom. Let’s take a look at the ISM which has been a good predictor of the real economy. Here’s the long term view:

What this shows us is that the current reading is consistent with past recessions and that this downturn, so far, is no worse than the last two recessions. What we don’t know is if it will get worse, but we do know that everyone expects it to. If this recession is as bad as the 1980-1982 double dip or the 1973-1974 recession, we’ve got more to go on the downside.

The next thing to look at is how long it takes for the ISM to start rising again. In the 1973-74 recession the ISM fell below 50 (indicating contraction) in August of 1974 and rose above it again in August of 1975:

In this recession, the first reading below 50 was actually in December of 2007, but the index didn’t really drop significantly until September 2008. It probably makes sense to use that as the starting point. So if this lasts as long as the ’74 recession we’ve got another 10 months to go before the ISM rises back above 50.

In the 1980-1982 double dip recession the index fell below 50 in August 1979, bottomed in March 1980, fell below 50 again in early 1981and didn’t rise above 50 again until early 1983.

How did the stock market react to the changes in the ISM? The ISM is a very good coincident indicator for the stock market. Stocks tend to bottom when the index hits its low and tends to peak when the ISM peaks. Here’s the chart for the S&P 500 during the 1974 recession:

As you can see, the S&P bottomed at the same time as the ISM and then rallied almost 50% as the ISM rose toward 50. In the 1980-82 double dip recession, the market again followed the ISM:

The market and the ISM bottomed in early 1980; the S&P rallied roughly 40% until late 1980 as the ISM peaked. The market then fell almost 30% as the ISM fell below 50 again;  the market bottomed in August 1982 just as the ISM hit bottom.

So what kind of expectations should we have for the ISM and the market from here? Well, there is no way to know the future, but it would seem that even if this is a deep recession like that of the 1970s and 1980s, the ISM is not far from its eventual low. A bottoming in the first quarter next year would seem  reasonable as it has generally taken roughly a quarter for the ISM to bottom. The exception is the second part of the double dip recession in 1981-1982. In that recession, the ISM stayed at a low level for almost a year and the stock market declined the entire time.

For a variety of reasons, I believe this recession could mirror the double dip of the early 1980s. The massive amount of stimulus, monetary and fiscal, being thrown around right now and likely in the first quarter of next year, could very well produce a temporary rebound in economic activity that lasts until late 2009 or early 2010. However, by the end of 2010, the economy will be facing a tax increase from the expiration of the early 2000 cuts. And that doesn’t include any other increases that may be coming from the new Obama administration.

In the short term, I am expecting the market to test the lows set in October and then as the ISM bottoms in the first quarter, the market can start on a more sustainable rally that carries into late 2009 or early 2010. That assumes that the new Obama administration holds off on tax increases until the Bush tax cuts expire. If they raise them sooner, it would likely choke off whatever recovery we get from the stimulus currently in the pipeline.

The ISM is only one tool and doesn’t give us any foreknowledge about the stock market. It does give us a good coincident indicator to watch for a bottom in stock prices. If stocks recover without a corresponding rebound in the ISM, it is unlikely to last. The November number may give us a clue as to whether the current rebound is sustainable; I suspect it is not.

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