Know Your Numbers: Purchasing Managers' Index

Looking at the mass of new economic data made available to the general public nearly every day, it's easy to understand how full-time economists keep their jobs. With every new piece of information, the overall perception of the U.S. economy changes -- sometimes in subtle ways and sometimes much more dramatically. Along with this change come changes in economic behavior, as various groups adapt their expectations and try to anticipate economic trends that have a significant impact on their personal and professional lives.

To get a complete picture of the state of the economy, analysts need to look at activity at different points along the chain of production. Some indicators, such as measures of personal income and spending, focus on actual transactions that reflect the choices consumers have already made. Other types of data, including information on consumer confidence, also examine the plans people are making for future spending decisions. Forward-looking information helps economists make accurate predictions.

The Institute for Supply Management, formerly known as the National Association of Purchasing Managers, releases monthly information that shines a light on the way various businesses are integrating decisions about orders, production, and employment into their overall strategies. In addition, regional reports from across the country provide similar information for their areas -- in some instances before the overall national figures are available. Here's a look at the way the institute gathers information on business supply management and compiles it into its benchmark index: the Purchasing Managers' Index, or PMI.

The basic concept
The PMI measures different types of activity that have an impact on the way manufacturing companies do business. To gather information, the Institute for Supply Management, or ISM, contacts more than 300 executives responsible for making purchasing and supply-related decisions. The monthly survey obtains information about new product orders, exports and imports of materials and products, inventory levels, current prices, levels of employment, response times for getting supplies, and changes in overall production. The survey also gets general impressions of business conditions, with participants limited to three responses: better, worse, or unchanged. Respondents are also encouraged to list important commodities that have risen or fallen in price or are in short supply.

Once the institute collects all of its data, it consolidates the information into five general categories: new orders, production, employment, supplier deliveries, and inventories. For each of the categories, the ISM creates a diffusion index that can range between 0 and 100; the index is calculated by taking the percentage of respondents reporting better conditions and adding in one-half of the percentage of respondents reporting unchanged conditions. Therefore, a reading of 100 would indicate that all respondents reported better conditions; a reading of 50 indicates equal numbers of respondents reporting better and worse conditions.

The ISM then applies seasonal adjustments that are provided by the Commerce Department to account for normal monthly conditions. To calculate the PMI, the institute takes each of the five category indexes and weights them: 30% for new orders, 25% for production, 20% for employment, 15% for supplier deliveries, and 10% for inventories. The resulting composite index is the headline number that you read about every month.

Although regional reports, like the Chicago report released Friday, employ similar methods, they are calculated directly by regional affiliates rather than by the ISM. Regional reports are often a strong indicator of what the national report will look like, but the surveys are independent of each other.

Economic implications
Like consumer confidence data, the primary value of the Purchasing Managers' Index is its simplicity. Readings of more than 50 indicate that the manufacturing sector is expanding, while readings of less than 50 suggest economic contraction. After reflecting pessimistic or near-neutral sentiment from 2000 to the middle of 2003, the PMI rose strongly in 2004 and has maintained optimistic levels ever since. The latest Chicago report indicated high levels of enthusiasm among regional purchasing and supply managers well in excess of expectations, suggesting that despite higher interest rates, energy and commodity prices, and consumer uncertainty, the economy may be more resilient than was previously believed. In contrast, regional information from Philadelphia released this month showed weakening economic conditions.

Because national PMI data is made available to the public immediately after the end of the month being measured, it's an extremely valuable indicator. Economists can use the PMI as a leading indicator for other data sets that take longer to compile and present, such as final GDP figures. Although consumers have been given credit for sustaining the economy through the difficulties of 9/11 and the end of the technology boom, many economists are hoping that business spending and investment will pick up the slack if consumers finally take a breather.

Regarding short-term interest rate movements, the PMI provides data for the Federal Reserve to use in gauging the strength of the economy. A strong report may convince the Fed that it can raise interest rates further without causing a recession, while a weak report may force it to consider cuts in the near future. This decision is especially important when the potential for a major change in interest rate policy is high.

In addition to the overall reaction of financial markets to news of changing economic conditions, investors may want to pay special attention to the information on commodity prices and supply levels. For instance, last month's national report listed steel and nickel as commodities in short supply. For investors in steel producers like U.S. Steel (NYSE: X  ) and Wheeling-Pittsburgh (Nasdaq: WPSC  ) or nickel makers like Inco (NYSE: N  ) , such information can be vital in trading the volatile futures markets while avoiding or taking advantage of supply-related squeezes.

The Institute for Supply Management's release of its PMI index gives the public a look at the opinions of manufacturing executives. The resulting figures provide early indications of whether the economy will grow or shrink in the near future, and financial markets often react strongly to unexpected moves.

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Looking for a mutual fund manager who will make the best investment choices in light of economic conditions? Champion Funds analyst Shannon Zimmerman focuses on finding ones who can anticipate changes in the economy and turn their insight into profit for you. Take a look at the newsletter for free with a 30-day trial.

Fool contributor Dan Caplinger has a degree in economics from the University of Chicago but prefers punditry to publishing 100-page papers. He doesn't hold positions in any of the companies mentioned in this article. The Fool's disclosure policy won't sell you short.


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