Importance Of Purchasing Managers’ Index (PMI) in Forex Trading

PMI, formerly referred to as Purchasing Manager’s Index, is a leading indicator that is most reliable for assessing the state of an economy. The headline indicator in the case of the US ISM Manufacturing Report is the PMI. This influential monthly survey involves interviewing executives handling the purchasing and supply functions across the US. Prior to September 2001, the acronym PMI represented Purchasing Managers’ Index. From September 2001 onwards the Institute for Supply Management (ISM) started using PMI as a separate acronym for reflecting supply management and not just the purchasing function alone. The ISM Manufacturing Purchase Manager’s Index Report on Business is closely watched by businesses, investors and financial professionals.

Data Collection

How Much Capital Is Required To Start Forex TradingThe PMI is computed based on responses collected from the members of the ISM Business Survey Committee. This includes representatives from a wide range of diversified industries in the North American Industry Classification System (NAICS) and is based on the contribution of each of these industries to U.S. GDP. As part of the survey, 18 industries in the manufacturing sector are covered.

Members are given a questionnaire every month. The questions are aimed at understanding the changes in the following 10 business activities:

#1: New orders from customers
#2: Production rate and direction of production level change
#3: Increase or decrease in employment
#4: Whether supplier deliveries are slower or faster
#5: Increase or decrease in inventories or stockpiles
#6: Inventories held by customers of organizations
#7: Whether the payments made by organizations for products and services are more or less
#8: Whether there is a growth or decline in backlog orders
#9: Whether export orders are growing or declining
#10: Change in the quantity of imported materials

The questions are sent to respondents during the beginning of each month. Respondents are directed to provide information that is relevant for the month under consideration. They provide the information by the end of the month. The data are then collated and compiled by the ISM to prepare and release the report on the first business day of the succeeding month.

PMI Calculation

The composite index is computed by allocating equal weightage, 20 percent each, to five of the primary sub-indexes: New Orders, Employment, Supplier Deliveries, Production and Inventories.

Sample Calculation

In June 2016, for example, the readings of the five sub-indices were as follows:

New orders – 57.0
Production – 54.7
Employment – 50.4
Supplier deliveries – 55.4
Inventories – 48.5

Applying 20 percent weightage to each index, the PMI reading came in at 53.2. Seasonal adjustments are applied to all the sub-indices except the inventories.

Diffusion Indices

ISM indices are diffusion indices and they measure the extent dispersion or diffusion in a group. Survey respondents have to indicate whether activity levels have become better’ whether they remain the same or have declined when compared with that of the previous month. The sub-indices for each of the business activity are computed by taking into consideration the respondents’ answer to the questions as to whether there is an improvement or deterioration in the condition. Then 50 percent of the respondents who report same level of activity are added to it.

PMI Interpretation

A reading of 50 percent, in general, indicates that there is no change from the previous month. If the reading is 100, it indicates that respondents are all reporting increased activity. On the other hand a ‘0’ reading indicates that the respondents are all reporting decreased activity.

Another key level to be noted is 43.2. If the PMI stays above this level for a period of time, it indicates an overall economic growth. In the US, the PMI crossed the 42.2 level in June 2009, marking recovery in the US economy after the credit crisis. In a press release following the announcement of the November 2016 PMI, the ISM said that the average 50.8 percent for the first six month of 2016 represented a 2.4 percent increase in real GDP on annualized basis.

PMI – Pros and Cons

Pros

The PMI provides indications about the business activities in a timely manner. This is because the data is revealed on the first day of the month that succeeds the survey.
Provides accurate indication on the status of the U.S. economy.
The PMI gives an indication about the health of the manufacturing sector in the US as a single number. Further, the Report on Business provides a wealth of information as regards the main business activities.

Cons

PMI covers only the manufacturing sector. Over the years, the importance of this sector to the country’s economy has diminished. As result, the ISM also provides another monthly report known as the ISM Non-Manufacturing Report on Business. This survey covers the U.S. services sector, which contributes more than 80 percent of the GDP.
Data from the survey is used to calculate the PMI and prepare the Report on Business. It is subjective is, therefore, prone to error.

PMI – How to Use It

The key leading indicator has the ability to move financial markets. If the latest PMI reading indicates an unexpected turnaround for the better or worse, traders should wait and confirm that other indicators also pointing out to the same condition. Traders should not make substantial changes to their portfolio on the basis of one reading.

Some of the key aspects that traders should keep in mind when using this indicator are as follows:

#1: They should look beyond the PMI number. The ISM Manufacturing Report on Business consists of invaluable information related to the U.S. economy as regards production, employment, prices and imports and exports. These numbers will be of great help to traders in better understanding the current status of the U.S. economy. It is better than making decisions on the basis of the PMI reading alone.

#2: Traders should remember the key PMI and sub-index levels. Like the PMI key level of 43.2, the sub-indices also have key levels. For example, the key levels for employment and production are 50.6 and 51.3, respectively.

#3: Traders should position their portfolios ahead of the ISM data release.

Final Thoughts

The leading indicator PMI is provides valuable information as regards the current general status of the U.S. economy and specifically that of the manufacturing sector. It is important that new investors make an effort to familiarize themselves with this economic indicator.

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