Can We Get Some Service Here?

Story Highlights:

• Markets reacted negatively today to a weaker-than-expected report tied to the US services sector.
• Because services make up a majority of GDP, some economists have proclaimed US recession is a reality. But this is false—a monthly survey bears no such information.
• The index in question (the ISM Manufacturing Index) is relatively new and subject to big revisions and anomalies in its monthly reporting. It should not be relied upon to proclaim economic deterioration so quickly.

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We don't use the term lightly, but something close to true hysteria broke out amongst stock investors today based on a very questionable economic indicator. We're speaking of course about the ISM's US Non-Manufacturing Index, which captures the US service industry and today posted a very low number. This sparked a market sell-off to the tune of +3% in world markets. It's even led some to proclaim a US recession is here.

Recession Is Here - Economists
By Chris Isidore, CNNMoney.com

This is simply a false statement. We've yet to have one negative quarter of GDP growth. Two quarters of negative GDP growth is the generally accepted rule of thumb for an "official" recession. There is no such certainty at this point, and in fact many economic indicators are showing strength. But folks do seem pretty convinced at the moment of economic doldrums.

Here is a breakdown and description of the survey and the most recent results:

U.S. Economy: Service Industries Unexpectedly Shrank
By Shobhana Chandra, Bloomberg.com

Today's surprisingly weak report suggests to us one of two things: Either the survey data is inaccurate (as some analysts suspect), or the non-manufacturing portion of the economy (which accounts for a hefty 90% of GDP) went into a significant and unexpected decline.

At least for the time being, there are good reasons to remain skeptical. The decline in the index is of similar magnitude to declines in October 2001 and September 2005. These drops were promulgated by the September 11th attacks and Hurricane Katrina. However, there was also a significant and seemingly inexplicable drop in March 2003, which also aroused high investor suspicion. But like September 2005, that was a false alarm and the ensuing reports showed sharp rebounds. The index should be monitored for such a rebound (or a revision) next month before drawing any rash conclusions.

At best, this indicator's record of predicting economic peril is shaky. However, we detected little such skepticism in market action today. Take, for example, this almost completely ignored positive news, also released today:

Factories Remain Solid as Orders Increase
By Jeff Bater, The Wall Street Journal

Moreover, the ISM index is barely ten years old. That's important because the best economic indicators usually need a much longer track record before they're considered reliable.

An important lesson in studying economic indicators—particularly as they pertain to stock markets—is not to put undue credence in monthly reports which can be volatile and sometimes flat out wrong. Remember these are complicated statistical calculations designed to represent reality. Often they fail.

But let's not sugarcoat the issue too much. If true, this is a negative result for a big part of the US economy. But it is a one month negative result in an index notorious for revisions and big rebounds afterward.

Market action like this is very uncomfortable and difficult to endure. Such volatility is never pleasant (unless of course it's the upward kind). In the past six months we've seen our fair share of similar sized upward and downward one-day moves. It's a turbulent time, but that's pretty common for stocks historically. Volatility alone shouldn't spook those with long time horizons.

Today didn't feel good. But remember such sharp jolts are designed to scare investors away at the most inopportune moments. Expect more bumpiness and sharp movements in the period ahead as knee-jerk reactions to economic data remain en vogue.