The U.S. manufacturing sector's return to expansion should be music to equity investors' ears, but bankers say past experience as well as the circumstances of the current rebound suggest a good deal of caution is warranted.

The U.S. Institute of Supply Management's (ISM) index of national factory activity rose to 52.9 in August, expanding for the first time since January 2008, data released on Tuesday showed.

While on the surface this might seem like good news, past correlation between the index and the equity market presents a more complex picture.

Based on a study comparing the range of ISM readings and the average S&P 500 <.SPX> index performance over a 60-year period, JPMorgan concludes that, when the U.S. manufacturing sector is in expansion mode, investors should take risk off the table.

In a nutshell, the 'second derivative' trade is getting exhausted, and the bullish view is becoming more mainstream, say JPMorgan analysts Mislav Matejka and Emmanuel Cau in a recent note.

This calls for a more balanced portfolio positioning.

In the bank's view the second derivative - based on the perception that the pace of economic contraction was slowing and an inflexion point approaching - is what has driven the 60 percent rally in global stocks over the six months.

JPMorgan's conclusions prompted it to downgrade the metal and mining sector, which typically benefits from strong economic growth, to neutral from overweight. It upgraded telecoms, which is a more defensive sector, to overweight.

From the trough of the ISM to 50, cyclicals tended to outperform defensives by 13 percent, but from 50 to ISM peak, the outperformance would slow to 5 percent, Matejka and Cau said.

WALL STREET OVERVALUED?

Also pointing to the ISM data as a guide, Credit Suisse reduced its recommended exposure to U.S. equities to 5 percent underweight from benchmark just before the numbers came out.

The worst phase of the cycle for the U.S. is when the ISM is above 50 and rising -- i.e. the phase we are in at the moment, Credit Suisse research analysts said in a note.

They said U.S. stock valuations looked slightly stretched compared with other developed markets and that U.S. households' liabilities were $3.5 trillion above trend relative to assets.

The S&P 500 had a one-year forward price-to-earnings ratio -- a measure of valuations -- of 14.93. That compared with 13.04 for the pan-European FTSEurofirst 300 <.FTEU3> index and 12.45 for Germany's blue chip DAX <.GDAXI>.

Philip Lawlor, chief portfolio strategist at Nomura in London, said the ISM's return above 50 might ordinarily provide a clue as to the timing of a U.S. rate hike -- one reason why equities might stall or even retreat as the economy expands.

But the circumstances surrounding the August numbers left the picture distorted.

It's premature, he said. The inventory rebuild ... has been driven partly by China and the 'cash-for-clunkers' incentive program for car buyers, which has now ended.

Lawlor also said unemployment had to fall before the market priced in raised expectations of higher rates.

(editing by John Stonestreet)

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