Here's why markets are reacting so negatively to the manufacturing report

Key Points
  • Manufacturing numbers were not just a miss, but a big mess.
  • The market, still near record highs, has a large downside risk.
  • Many sectors of the market are overbought.

The big miss on the September manufacturing is a big problem for the markets.

The S&P moved in a 50 point range,  Or 1.6%, lower since the ISM report came out at 10 a.m. ET. This a very large move. Since 1998 the S&P has moved more than 1% on days the ISM has reported less than 8% of the time, according to Paul Hickey at Bespoke Investing.

In particular, sectors sensitive to manufacturing and the global economy saw significant declines, including Industrials, Materials, Energy, and Bank stocks, which also dropped because bond yields dropped.

It's well known that global manufacturing has been in contraction; the markets seem to be signaling a broader concern, that weakness may bleed into the U.S. consumer that is holding up the global economy.

"This makes the jobs report on Friday very important," Alec Young, Managing Director of Global Markets Research for FTSE Russell, told me.

"All it takes is one jobs report for people to connect the dots that consumer is weaker," he said.

The outsized reaction was partly the sheer size of the miss: It was not just a big miss (47.8, versus expectations of 50.1), it moved the index into contractionary territory (below 50), and it was the lowest reading in 10 years.

The other reason for the outsized reaction: Despite all the turmoil around global trade and a weaker global economy, the S&P is still 3% from historic highs. That means stocks are still expensive, and risks to the downside remain high.

Markets have remained near their highs because of rotation: as cyclical sectors like Industrials, Materials, Retailers, and Energy have fallen out of favor, investors have bought defensive Consumer Staples, REITs, and Utilities. That leaves many sectors, particularly defensive sectors like Consumer Staples, overbought.

The result: Markets are in a trading range. The one immediate issue that can get us out of that range--trade negotiations--are expected to restart next week. But expectations for those negotiations remain low.

What to watch? Young advises paying attention to the small group of consumer names that have been growing market share and whose prices are up dramatically this year : Nike, McDonald's, Starbucks, Home Depot, Costco, and Ross Stores, all of which are up 20% or more.

If there are concerns about the consumer, those are the first that will sell off.