The ISM manufacturing index came in below 50, which usually sends stocks reeling. But that didn't happen this week — instead, stocks remained strong.
When that divergence happens, it prompts some murmurs of a conspiracy theory — that the Federal Reserve may be buying stocks to prop up the market. I'm no conspiracy theorist but I do think the market action is due to the Fed — just not in the way that the conspiracy theorists suggest.
We are living in the age of the "rock star" central banker. Ben Bernanke gets a reported $200,000 per speech, while trading stops whenever Janet Yellen or Mario Draghi open their mouths. In my 20 years on Wall Street I have never needed to know the voting record of every Fed governor like I do now. The rock star central banker can make trillions of dollars move with just a few words. But should they?
Prior to the Great Financial Crisis, the mantra for central bankers was that "good central banking should be boring." However, the panic that occurred during 2008 required central bankers to step out of the shadows and make some noise. The problem with being a rock star central banker is that when it's time to end the show, the crowd inevitably screams for more. In the recent past, this meant another round of quantitative easing by the Fed, but with the U.S. central bank ready to raise interest rates, an encore is unlikely.
The correlation between the ISM Manufacturing Index and stock-market returns is very strong. The following chart depicts the ISM manufacturing index and the yearly percentage change in the S&P 500.
Source: St. Louis Federal Reserve
This chart goes all the way back to 1949 and clearly shows that stock market returns follow the ISM index. If we take a closer look at recent history we see a similar pattern but with one big difference.
The last time the ISM Manufacturing Index dropped below 50 was in November of 2012. In fact, the index had been falling for months but the stock market kept rising. The cause of this divergence was the expectation of more quantitative easing by the Fed. Indeed in September 2012, the Fed launched "QE3" and the stock market rejoiced.
Source: St. Louis Federal Reserve
The highlighted portion of this chart shows that from June 2012 (when the ISM index began to drop toward 50) until September 2012 the S&P 500 climbed almost 20 percent. Investors were correct to anticipate more stimulus from the Fed, but is it different now?
The big difference is the willingness of the Fed to announce another round of quantitative easing, which would be QE4. The low unemployment rate has convinced many Fed governors that the U.S. economy is about to take off. The ISM reading contradicts this belief. As well, many believe that the European Central Bank will ride to the rescue by adding to its own QE program. The problem with this logic is that ECB QE will weaken the euro and strengthen the U.S. dollar. A strong U.S. dollar is likely to weigh further on the U.S. manufacturing sector.
Up to this point, investors have been correct to believe in the rock star central banker, it's been one heck of a show. However, as one rock star leaves the stage the next act may not live up to the hype. Given the inevitable impact of a strong dollar, the next act may get booed off the stage. Sorry Mario.
Brian Kelly is founder and managing member of Brian Kelly Capital LLC, a global macro investment firm catering to high net worth individuals, family offices and institutions. He is also the creator of the BKCM Indexes, benchmarks for multi-asset money managers. He's also the author of the upcoming book, "The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World." Kelly, a CNBC contributor, often appears on "Fast Money." Follow him on Twitter @BKBrianKelly.
