The Importance of the Purchasing Managers' Index

One of the most reliable leading indicators for assessing the state of the U.S. economy is the PMI, formerly known as the Purchasing Managers' Index.

PMI is the headline indicator in the ISM Manufacturing "Report on Business," an influential monthly survey of purchasing and supply executives across the United States. The acronym PMI stood for Purchasing Managers’ Index prior to September 1, 2001. But since that date, the Institute for Supply Management (ISM) has used PMI as a stand-alone acronym to reflect its corporate name change (the ISM was called the National Association of Purchasing Management – NAPM – until January 2, 2002) and broader reach into strategic supply management beyond just the purchasing function.

The ISM Manufacturing "Report on Business"  and the PMI number is closely watched by investors, business and financial professionals.

The PMI is based on responses from members of the ISM Business Survey Committee, which includes a range of industries diversified by the North American Industry Classification System (NAICS) and based on each industry’s contribution to U.S. GDP. The survey covers 18 industries that include every aspect of the manufacturing sector.

Members receive a monthly questionnaire that asks them to identify month-over-month changes for the following ten business activities that also constitute individual indexes in the Report on Business survey:

• New orders – from customers
• Production – rate and direction of change in the level of production
• Employment – whether increased or decreased
• Supplier deliveries – are they slower or faster?
• Inventories – increases or decreases in stockpiles
• Customer Inventories – rates the level of inventories held by the organization’s customers
• Prices – reports whether organizations are paying more or less for products & services
• Backlog of Orders – measures whether the order backlog is growing or declining
• New Export Orders – measures the level of export orders
• Imports – measures the rate of change in imported materials.

The surveys are sent out to Business Survey Committee respondents in the first part of each month, and respondents are asked to report information only for the current month. Most survey respondents wait until late in the month to respond to the survey in order to portray the clearest picture of current business activity. The ISM collates the data and compiles the report for release on the first business day of the following month.

The PMI is a composite index based on equal weights (20%) of the following five primary sub-indexes – New Orders, Production, Employment, Supplier Deliveries, and Inventories.

For example, in the June 2016 Manufacturing ISM Report on Business, the five sub-index levels were as follows – New Orders 57.0, Production 54.7, Employment 50.4, Supplier Deliveries 55.4, and Inventories 48.5. Based on a 20% weight to each sub-index, the PMI reading was therefore 53.2.

Seasonal adjustments, which are developed by the U.S. Department of Commerce and provided to ISM, are made each year in the January reports to four of the five sub-indexes (Inventories being the exception). These seasonal adjustments are made to adjust for the effects of recurring intra-year deviations due to normal differences in weather conditions, holidays etc.

All ISM indexes are diffusion indexes, which measure the extent to which a change is dispersed or diffused in a group. For each of the 10 business activities, survey respondents are asked to indicate whether it has become better, worse, or has stayed the same, as compared to the previous month. The individual indexes for each business activity such as production, employment, etc. are calculated by taking the percentage of respondents who report that the activity has improved (i.e. is higher or better) and adding it to one-half of the percentage who report unchanged activity.

For example, if 40% of the respondents report that employment, say, has increased, while 35% report no change and 25% report a decrease, the diffusion index would be: (40% + [0.5 x 35%]) =  57.5%.

For a diffusion index in general, a reading of 50% indicates no change from the preceding month, while the further away the index reading is from 50%, the greater the rate of change. A reading of 100 indicates that all survey respondents are reporting increased activity – as may be the case in an exceptionally strong economy – while a reading of 0 indicates that all respondents are reporting decreased activity.

A PMI reading over 50 or 50% indicates growth or expansion of the U.S. manufacturing sector as compared to the previous month, while a reading under 50 suggests contraction. A reading at 50 indicates that the number of manufacturers reporting better business is equal to those stating business is worse.

Another key number to watch is 43.2, since a PMI index above this level over a period of time indicates an expansion of the overall economy. The June 2016 PMI reading of 53.2 indicates that the U.S. economy expanded for the 85^th consecutive month, as the PMI first surpassed the 42.2 level in that expansion in June 2009, which coincidentally also marked the start of the post-credit crisis U.S. recovery as determined by the National Bureau of Economic Research. The June 2016 PMI figure also indicated that the U.S. manufacturing sector had grown for the fourth successive month.

In its press release detailing the November 2016 PMI, the ISM noted that based on the historical relationship between the PMI and the overall economy, the average PMI level of 50.8% in the first half of 2016 corresponded to a 2.4% increase in real U.S. GDP on an annualized basis.

Strengths

• The PMI is a timely indicator, as it is released on the first day of the month after the one in which the survey was conducted.
• Accurate leading indicator on the state of the U.S. economy.
• The PMI condenses the health of the U.S. manufacturing sector into a single number, while the Report on Business contains a wealth of information on main business activities.

Weaknesses

• The PMI only covers the manufacturing sector, whose importance to the U.S. economy has been diminishing over the years. The ISM also reports another monthly report, the ISM Non-Manufacturing Report on Business, which surveys and reports on the U.S. services sector that represents over 80% of GDP.
• The Report on Business survey, data from which is used to calculate the PMI, is subjective and may therefore be prone to error.

The PMI is an important leading indicator that can move financial markets. However, if the latest index reading suggests an unexpected turnaround in the economy – for better or worse – it may be best to wait until other indicators also confirm the economy’s turnaround, rather than making wholesale portfolio changes on the basis of a single reading.

The following points should be borne in mind with regard to the PMI:

• Look beyond the headline PMI number – The ISM Manufacturing Report on Business contains invaluable information on key aspects of the U.S. economy such as production, employment, prices, and exports / imports. Delving into the numbers will enable you to get a better read on the U.S. economy than going by the PMI figure alone.
• Remember key levels for the PMI and sub-indexes – Just as 43.2 represents a key level for the PMI as noted earlier, the major sub-indices have key levels that are worth noting. For example, an Employment Index above 50.6 over time is generally consistent with an increase in non-farm payrolls as reported by the Bureau of Labor Statistics. Similarly, a Production index above 51.3 over time is consistent with an increase in the Federal Reserve’s industrial production figures.
• Position portfolios in advance of the ISM data release – Since the PMI can be a market-moving number, it may be best to position portfolios ahead of the data release. If the U.S. economy is growing strongly and the PMI number is expected to add to the bullishness, it may be worthwhile buying U.S. equities in advance of the report’s release. Conversely, if expectations are for a weak PMI number, it may be prudent to trim some U.S. equity exposure prior to the report’s release.

The PMI is an important leading indicator that provides valuable insights into the state of the U.S. economy in general and the manufacturing sector in particular. While it tends to be occasionally overlooked, new investors should familiarize themselves with this key economic indicator.