Institute for Supply Management (ISM) for Profitable Forex Trading
Updated: Apr 1, 2021
The ISM.
Whether you are googling it or searching for it on Wikipedia, you will notice one thing: a surprisingly large amount of organisations uses this abbreviation.
However, as traders, you should be looking at one organisation only bearing this abbreviation: the Institute for Supply Management.
In this article, we will be looking at the following points:
Oh - and yes: the TLDR version is right at the end.
What is ISM PMI and ISM NMI?
Already founded in 1915, the ISM is among the oldest, largest and well-respected institutions focusing on supply management in the world.
With up to 50,000 members across the world, the organisation teaches and trains professionals, and conducts research, which findings they publish every month.
But wait - hold on a minute... What is supply management in the first place?
Supply management is used to analyse and provide the goods and services that a company needs, to fulfil its objectives.
In other words, they look for ways to link organisations with each other, in order to allow them to reach their goals by looking at logistics, quality management, or methods of distribution.
Essentially, this involves everything that a company would need to ultimately produce a good or deliver a service.
Using this, the current business activity levels in an economy can be gauged.
Every month, the ISM produces three reports:
ISM Manufacturing Index Definition
ISM Manufacturing Index or the Purchasing Manager’s Index (PMI), published on the first business day of the month, focuses on the production of goods
ISM Non-Manufacturing Index Definition
ISM Non-Manufacturing Index (or NMI) or Services PMI, published on the third business day of the month, focuses on the delivery of services.
ISM Hospital PMI Definition
ISM Hospital PMI, published on the fifth business day of the month, focuses on hospital activity.
The main difference between these reports is that the manufacturing ISM report focuses on those companies, which produce goods, or things that you could touch or feel.
Instead, the non-manufacturing index focuses on the services – think of financial services, transportation, or health services. Lastly, the hospital PMI revolves many around the activity of hospitals and other healthcare-related activity.
Why is ISM Manufacturing Index Important?
You now might wonder: why is the PMI important? Well, as mentioned earlier, the ISM conducts their research and publishes their findings on a monthly basis.
With such a good reputation and long-standing history, you could already imagine that they somehow are good at what they do.
In fact, they are so good at what they do and their work has been so significant, that other countries have copied the ISM’s methods of investigating the business activity of their own economy.
The ISM has an interesting way of doing their research: they create a large
survey that they send out to those people in a company who are responsible for buying products and services, which the company eventually uses or resells: the purchasing managers of more than 300 manufacturing firms.
In this survey, the ISM simply wants to know about what the companies are purchasing, and how these companies are filling their orders.
Now, you have to think of the ISM as an institution that is asking what these companies are purchasing.
With that knowledge, the ISM creates a report that essentially indirectly shows what and how these companies are thinking about the current as well as the future state of the economy.
You know, it is just part of the field of economics.
Hence, knowing what the ISM does essentially turns out to be very important. Why…?
Because the firms themselves make up the economy – essentially being a self-fulfilling prophecy – and who is better at gauging the state of the economy? Right – those purchasing managers.
Imagine the following: most of the firms are very optimistic about the economy, and realise that there is a high demand for their goods. The purchasing managers have to buy the materials that are used to produce the goods, which are in demand.
The ISM Manufacturing Index therefore rises, when the majority of purchasing managers are more optimistic. The opposite happens when firms are less optimistic about the economy.
I know that we are somewhat used to it after spending more than one year in lockdown, but just, for the sake of this example, *imagine* that a recession is coming our way.
We, as consumers start to hesitate and lose confidence about the economy, and we will start to spend less – the manufacturers of goods also start to lose confidence, and order their purchasing managers to reduce their purchases.
The PMI starts to fall, and indeed, the economy, made up by both consumers and firms, starts to shrink.
This brings us nicely to the PMI’s relationship with the GDP, or the output of an economy.
As a leading indicator for the economy, the PMI even precedes or predicts what would happen with the economy. The following chart shows the relationship between the GDP growth rate (quarter on quarter) and the PMI scores from 2000 until now.
What we can see is that there is quite an obvious relationship and very strong correlation between the GDP growth rate and the PMI.
Whenever the PMI starts dipping below the 50 benchmark, the GDP’s growth decreases as well. Whenever the PMI starts increasing above the 50 benchmark, the GDP’s growth increases.
By now, you would already understand how relevant the monthly ISM reports are.
However, there is one thing that we would like to show you. The ISM uses data collected from purchasing managers of large US manufacturing firms.
In that case, you could already imagine that there could be a potential relationship between the ISM reports – in this case, the PMI – and one of the most important stock market indices of the US, consisting of many of the largest US companies: the S&P 500.
The following chart shows an overview of the both the monthly PMI change and the monthly S&P 500 change:
What do we see?
For instance, when the PMI increases, the S&P 500 also increases. On the other hand, when the PMI decreases, the PMI also decreases.
Based on this, we could also research and investigate the PMI to see what purchasing managers are thinking about how the stock market will perform!
ISM Manufacturing Index - How Does it Work?
Understanding why it is relevant, we would now move on to the following point: how
does it work? The previous sections have already touched upon this briefly.
In the following, we are focusing mainly on the PMI. As it is the oldest indicator from the ISM, and therefore the most reliable.
Furthermore, knowing how the PMI works would also allow you to understand how the NMI works.
Remember, the ISM sends out a survey each month to approximately 300 purchasing managers of manufacturing firms, and the results from the survey allow an index number to be composed.
The survey is made up of ten different categories, that we can see right here.
You could imagine that the ISM has a lot to do, to filter and go through all the purchasing managers’ answers. By the end of each month, most survey responses are slowly coming in and gradually shed a light on the business activity at that moment.
Thankfully, the people at ISM really do want to make everybody’s life a bit easier.
The ISM condenses all these survey responses into one nice little statistic: the index. What happens is that each sub-index is summarised in one little number, and each category accounts for a part of the overall index.
This then results in an average number, the Composite PMI. For instance, for the month of January 2021, the ISM PMI shows a score of 58.7.
What we also have to understand that if the PMI is larger than 50 (PMI > 50), the economy is indicated to be expanding or growing – in the eyes of the purchasing managers.
In contrast, if the PMI for that month is smaller than 50 (PMI < 50), the economy is indicated to be contracting/shrinking.
The ISM condenses all monthly survey responses into one index - showing whether the economy is growing or shrinking!
The ISM people are in fact also very kind – and have summarised and categorised their results according to each manufacturing industry, quoting the overarching themes for each industry such as Computer & Electronic Products, Chemical Products, Transportation Equipment, etc.
What these respondents think should give a better picture of what the business activity looks like in each industry.
In one case, we could see that Mr Chemical Products has been very optimistic, whereas Mrs Food, Beverage & Tobacco is struggling with finding enough workers.
Over the years, the PMI scores have varied wildly. For instance, looking at the overview of the PMI scores between 1948 and the most recent score of 2021, we see that there have been times where the PMI was below 50, and also (longer) occasions where the PMI was higher than 50:
So – that is essentially how the PMI works and yes, the same methods are used for the Services PMI (or the Non-Manufacturing Index, NMI) and the Hospital PMI!
How To Use the PMI to Make Bank
You might think now: that is all very nice, fun and games, etc., but how do I make bank using the ISM PMI, or the NMI, like you mentioned before?
We would like to ask you to hold on tight, because we are going to tell you in just a little bit. First, let’s recap a little bit.
What do we know?
Well, we know that the PMI is published every first business day of the month, and that consists of a large sample of survey responses from purchasing managers across the US.
These responses then indicate whether a specific sub-index is growing or shrinking, and an overall PMI number is constructed.
Great – now what...?
Looking at the headline for January 2021’s PMI publication, we can see that the Manufacturing PMI has recorded at 58.7. Based on January’s release, we could say that the economy is in fact growing! However, there is another thing we should pay attention to: the direction in which the PMI is moving.
Taking a step back and finding out what the previous PMI was, we will see that the PMI was 60.7 in December 2020:
Our conclusion? The PMI is higher than 50 – indicating the economy is growing – but the growth has slowed down, with a change of -1.7.
Being a leading indicator in the grand scheme of the global macro trading strategy, i.e., an indicator that could predict the GDP growth in the future, we could see that in an inflationary situation, the purchasing power of the currency goes down.
After all, the higher the amount of currencies in circulation, the weaker the value of the currency becomes. As a trader, you could definitely consider then to short the currency at hand!
The opposite is true for when the PMI is below 50 and the economy is contracting. In some cases, the ISM could be below 50 and decreases at a larger rate than before, whereas in other situations, the PMI decrease starts to slow down.
Regardless, with an ISM below 50, there is a strong indication that the economy is contracting – and you know what: with non-stonks, money becomes more valuable and a long bias can be seen!
Just take a moment to imagine the following: the ISM has been growing hard for quite some time now, and at some point has reached its climax. What do you think would happen?
With a very high PMI score, the economy has been growing and followed suit. However, an economy naturally could overheat, and as a result, the authorities could decide to cool down the economy.
When you are keeping an eye out for the PMI scores, you should also consider whether the PMI’s top is in – or the bottom! When the climax has been reached, you could assume that exact opposite of your current economic state could happen.
Instead of growth, there will be a period of cooling down – and instead of underperformance, there is a high chance of firing up the economic engine again.
Is it that simple? Perhaps, yes, but obviously, a sensible FX trader would not just jump straight into a trade – and he needs more variables. However, at the bare minimum, the PMI is a great indicator to use for trading.
How Forex Traders Use ISM Report for Profit - Summary
Of course, in case you wanted to skip straight through the article and simply want to know how to use the PMI to improve your trading - here is the TLDR version!
The PMI is released on the first business day of the month, and it includes the results of a survey sent to purchasing managers of 300 firms. The PMI has the capability to predict the direction in which the economy is going – either growing, or contracting.
With a monthly PMI release of > 50
and growing from the previous statistic: expanding economy more money in circulation - short bias
and decreasing from the previous statistic: expanding economy more money in circulation - short bias (but check again whether the top has been reached)
With a monthly PMI release of < 50
and decreasing from the last number: contracting economy less money in circulation - long bias
and increasing from the last number: contracting economy less money in circulation - long bias (but check again whether the bottom has been reached)
Now, knowing this: go out, keep an eye out on the PMI – and let’s get this bread!
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