Trader Tip: PMIs Explained In general we traders, trade mostly off of technical indicators, but we should be aware of fundamental indicators as well. These fundamental indicators can help give some background on trends we see, in terms of their potential strength. There other point here is that markets trade off of catalysts. If the market wants to move, it often searches for a reason. A fundamental number that is off expectations can do just that. This is why we daily look at potential economic news releases to ensure we don’t get surprised in the daily trading battle. Fundamental indicators give us the broader trends, where technical indicators give us that day to day single to Trigger a trade.
One of my favorite fundamental indicators is the PMI. Why? I believe it is one of the more forward looking indicators we have. Most others, like GDP, employment data, earning reports can often lag by months when released. However, these more lagging indicators can and must eventually confirm the leading indicators. So in this article let’s look at a high level what PMIs are and how we might be able to use them in our trading. So just what is the PMI?
The Purchasing Managers’ Index (PMI) is an indicator of economic health for manufacturing and service sectors. The purpose of the PMI is to provide information about current business conditions to company decision makers, analysts and purchasing managers. Though the the data collected is a survey, these Purchasing managers form a near ideal survey sample base, having access to information often denied to many other managers. Due to the nature of their job function, it is important that purchasing managers are among the first to know when trading conditions, and therefore company performance, change for the better or worse.
PMI data are presented in the form of a diffusion index, which is calculated as follows:
PMI = (P1 * 1) + (P2 * 0.5) + (P3 * 0)
- P1 = Percentage number of answers that reported an improvement.
- P2 = Percentage number of answers that reported no change.
- P3 = Percentage number of answers that reported a deterioration.
The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared to the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change. The further from 50 is greater the level of change. A key feature of the PMI surveys is that they ask only for factual information. The purchasing managers is carefully selected. They are not just surveys of opinions, intentions or expectations and the data therefore represent the closest one can get to “hard data” without asking for actual figures from companies.
The PMI is made up of several different surveys that include a number of elements such as:
- New orders
- Factory orders
- Employment levels
- Supplier’s delivery times
The purchasing managers participating in the survey will generally answer questions about these and other elements used in the survey with either “improvement,” “no change,” or a “deterioration.” The answers are scored and the results are tabulated. Typically we get this economic data for both manufacturing and non-manufacturing sectors of the economy – as well as country by country. JP Morgan even puts out a global PMI (a consolidation of existing PMI data).
There are mostly two organizations that regular (monthly), publish PMI data, though their are others. The ISM Manufacturing Index is based on surveys of more than 400 manufacturing firms by the Institute for Supply Management (ISM). Markit Economics collects data from more than 20,000 companies across more than 30 countries every month. So which is better?
Markit’s survey typically provides a smoother trend, with a lower “noise to signal” ratio. Markit’s survey panel is nearly twice as large as the ISM’s stated panel size, is very closely mapped against the official structure of the economy and uses a different method of seasonal adjustment, calculating the factors every month instead of once per year. The two surveys have different weights for each component. Markit index has a correlation of 94% compared with 87% for the ISM data (though this would need further confirmation). However ISM does tend to focus more heavily in the North American regions, and some believe it to better for this region. Both PMI reports are looked at by the markets, so one perhaps does not need to pose this question.
You can find the releases of these PMI reports from both ISM (click here) and Markit (click here). Do note that these links can change – these are the current links at the time of this post. It is worth spending a few minutes scanning a few of these reports to get familiar with them. That being said, when we see these fundamental indicators released by these organizations, should we care and how can we use them in our day to day trading? Perhaps so. Here is my quick hit list of how they might be used, understanding that for an economist it merely scratches the surface:
- PMI data for traders is about the expectations game. It can extend current trends, cause breakout trades and/or stall/reverse an existing trend.
- When judging longer term trends, one outlier PMI number can be reversed the next month. It is best to look at a moving three month average.
- When PMIs get above 55, or below 45, it tends to reverse and/or stall from there. I believe survey respondents tend to not be extremists in there responses. A note when playing the expectations game.
- Remember PMIs are survey data, if the market wants to ignore this data, it often will, in favor of a prevailing trend.
Again, this is just a quick overview of PMIs and how one might use them in our day to day trading, but something you should be aware of as a trader. Click here, or watch below a video presentation of this Trader Tip.
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