Lesson 66 – How to Interpret the ISM Manufacturing Index

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In our last lesson we looked at the Retail Sales number and how this indicator gives us an early insight into the growth of private consumption, the largest category of GDP.In this lesson we are going to look at another market moving indicator which helpsmarket participants anticipate growth in the manufacturing sector of the economy,the Institute for Supply Managements’ Manufacturing Index.

Reported on the first business day of the month at 10am EST, the Institute for SupplyManagement (ISM) Manufacturing Index is comprised of several different sub indicesthe 5 most important of which are:

  1. The Production Index which gives insight into industrial production
  2. The Prices Index which gives insight into the Producer Price Index (an important inflation gauge which we are going to learn about in future lessons).
  3. The New Orders Index which is used to predict Factory Orders
  4. The Employment Index which is used to predict manufacturing employment.
  5. The supplier deliveries index which is a component of the leading economicindicators index, another important indicator which is designed to predict futuregrowth or lack thereof in the economy.

The sub-indices and therefore the headline number are derived by a national monthly survey of purchasing executives at several hundred industrial companies. As a part ofthis survey these influential manufacturing executives are asked a series of questions to gauge the level of growth or lack thereof their companies are experiencing in the above components. In response to these questions the executives can give only one of three answers which are: better, the same, or worse.

As stated on the ISM’s website once these answers are received “The ISM indexes are calculated by taking the percentage of respondents that report that the activity has increased (“Better”) and adding it to one-half of the percentage that report the activity has not changed (“Same”) and adding the two percentages. Using half of the”Same” percentage effectively measures the bias toward a positive (above 50 percent) or negative index. As an example of calculating a diffusion index, if the response is 20 percent “Better,” 70 percent “Same,” and 10 percent “Worse,” the Diffusion Index would be 55 percent (20% + [0.50 x 70%]). A reading of 50 percent indicates “no change” from the previous month.”

There are two things which it is important to understand about the resulting numbers which are:

  1. A reading above 50 indicates an expansion over the previous month in the component index or in overall manufacturing if you are looking at the main number and a reading below 50 indicates a contraction.
  1. Generally releases which beat estimates to the upside will rally the markets and releases which beat estimates to the downside will result in market sell offs. This is especially true, and moves can be especially large, around turning points in the economy where uncertainty reigns and a leading indicator such as this carries a lot more weight.

Although the US economy is now primarily a service based economy, the ISM Index is still one of the most important and therefore market moving indicators for several reasons. Firstly, although no longer the dominant part, manufacturing still plays a large role in the US economy. Secondly, the prices paid and employment components of the indicator give a read on what is happening with inflation and the labor market, two very important components of the economy. Lastly and perhaps most importantly is the fact that before goods are sold to businesses and consumers they have to be manufactured so this is in general the first area where signs of strength or weakness in the economy tend to show up. The ISM Index is therefore considered a leading economic indicator or one with predictive powers on what is going to happen in the next several month with the economy.

As with all the other indicators we are studying it is important to follow the release for several months to get a feel for what the market focuses on and how it reacts, so you can begin to anticipate market reactions and incorporate this into your trading. With this in mind, and as with the other indicators here as well, I will be posting a discussion starter in the comments section of this lesson on the date of the next release a link to which you can also find in the description section if you are watching this on Youtube.

That concludes our lesson. In our next lesson we will turn our attention to some of the indicators which focus more on inflation than economic growth starting with a discussion of the Producer Price Index.