ISM Manufacturing Index PMI: Backtest Insights
Introduced by the ISM in 1948, ISM Manufacturing Index, or PMI, is a useful resource for assessing the health of the US manufacturing sector. It is one of the key macroeconomic indicators financial market traders monitor on economic calendars because of the impact it can have on various financial markets. Unexpected results can move different markets, including stocks, indexes, and currencies. Let’s take a look at the ISM Manufacturing Index.
The ISM Manufacturing Index, or PMI is an important indicator of the health of the US manufacturing sector. The index is based on a survey of manufacturing purchasing managers and measures factors such as production, new orders, employment, and supplier deliveries. A reading above 50 indicates that the manufacturing sector is expanding, while a reading below 50 indicates that it is contracting.
In this post, we answer some questions about the ISM Manufacturing Index trading and investing strategy, plus backtesting.
ISM Manufacturing Index PMI – stock market return – video
Are ISM and PMI the same?
First, let’s establish that the ISM and PMI are the same. It’s published at the beginning of every month.
How is the ISM manufacturing index calculated?
The ISM Manufacturing Index is an important indicator of the health of the US manufacturing sector. The index is calculated using a survey of manufacturing purchasing managers on factors such as production, new orders, employment, and supplier deliveries.
The survey asks respondents to rate a variety of indicators on a scale of 0 to 100, with a reading above 50 indicating manufacturing sector expansion and a reading below 50 indicating manufacturing sector contraction. The survey results are then weighted and combined to generate the final ISM Manufacturing Index.
Here is the formula for calculating the index:
PMI = (P1*1) + (P2*0.5) + (P3*0)
Where:
P1 = % of answers reporting improvement
P2 = % of answers reporting no change
P3 = % of answers reporting deterioration
The index is published on the first business day of each month by ISM (Institute for Supply Management). It is closely followed by financial analysts, investors, traders, economists, policymakers, and businesses because it provides insight into the economy’s direction and has the potential to impact financial markets. The index helps them to gauge manufacturing activity and associated economic growth. It also helps professionals understand existing and future business situations.
What is the significance of a reading above 50 on the PMI?
The PMI is a closely watched economic indicator that measures the health of a country’s manufacturing sector. It helps analysts, investors, traders, economists, and businesses gauge manufacturing activity and associated economic growth. Professionals also use it to understand existing and future business situations.
A reading of 50 or higher indicates that these factors are improving and the manufacturing sector is expanding, whereas a reading of 50 or lower indicates that these factors are deteriorating and the manufacturing sector is contracting. The PMI is useful for traders and investors because it provides insight into the economy’s direction and has the potential to impact financial markets.
How is the PMI used by investors and businesses?
Investors and businesses use the Purchasing Managers’ Index (PMI) to assess the economic health of the US manufacturing sector. It provides insight into the economy’s direction and has the potential to affect financial markets. For example, if the PMI rises, it may indicate that the manufacturing sector is expanding and the economy is improving, which could lead to increased investor confidence and, as a result, higher stock prices.
On the other hand, if the PMI falls, it may indicate that the manufacturing sector is contracting and the economy is deteriorating, which could lead to decreased investor confidence and a drop in stock prices. In addition to its use in financial markets, the PMI can be used by businesses to make informed decisions about their operations. A company, for example, may use the PMI to assess the health of its supply chain or the demand for its products.
Can the PMI be used to develop trading strategies?
Yes, the PMI can be used to develop trading strategies. Traders and investors can use the PMI to make informed decisions about the direction of the economy and to develop trading strategies accordingly.
For example, if the PMI rises, it may indicate that the manufacturing sector is expanding and the economy is improving. Stock traders would interpret it as a bullish signal on stocks and may consider implementing a bullish trading strategy, such as purchasing long positions in stocks or index futures.
On the other hand, if the PMI falls, it may indicate that the manufacturing sector is contracting and the economy is deteriorating, which could lead to decreased investor confidence and a drop in stock prices. In this case, a trader or investor may consider a bearish trading strategy, such as selling short positions in stocks or index futures.
We have backtested such strategies later down in the article.
How accurate is the PMI in predicting economic activity?
The Purchasing Managers’ Index (PMI) is widely regarded as an accurate indicator of economic activity. Seasonal fluctuations, changes in global economic conditions, and other external factors may all have an impact on the PMI.
However, the PMI is a backward-looking indicator, reflecting past economic activity rather than forecasting future economic conditions.
How does the PMI compare to other economic indicators in terms of reliability?
The PMI has the advantage of being based on a survey of purchasing managers in the manufacturing industry, who are often among the first to notice changes in economic conditions. As a result, the PMI can provide an early indication of the economy’s direction.
Furthermore, the PMI is based on a variety of indicators, such as production, new orders, employment, and supplier deliveries, which can provide a broad picture of economic activity.
Can the PMI be used as a leading indicator of economic conditions?
The PMI is a backward-looking indicator, reflecting past economic activity rather than forecasting future economic conditions.
It provides information on sales, employment, inventory, and pricing. Purchases in the manufacturing sector tend to respond to consumer demand and are frequently among the first signs of a slowdown. The PMI is also one of the most closely followed economic indicators because it is the first major survey released each month.
Please also keep in mind that financial markets are looking forward. When bad PMI numbers hit the tape, it might be yesterday’s news.
How does the PMI take into account seasonal adjustments?
Seasonal adjustments are frequently made to economic indicators, such as the PMI, to account for regular patterns in economic activity caused by seasonal factors such as weather, holidays, and other external factors.
For example, the PMI may be adjusted because summer production and employment tend to be higher due to increased demand for goods and services.
How is the weighting of the various factors that make up the PMI determined?
The relative importance of each factor in the overall health of the manufacturing sector is used to determine their weighting in the Purchasing Managers’ Index (PMI). The weighting of each factor is typically determined by statistical data analysis.
The relative contribution of the factor to changes in the PMI over time can also be changed as the relative importance of each factor changes over time.
Can the PMI be used in conjunction with other economic indicators for a more comprehensive understanding of economic conditions?
Yes, the PMI can be used in conjunction with other economic indicators for a more comprehensive understanding of economic conditions.
Some other economic indicators that can be used in conjunction with the PMI include GDP, employment data, consumer confidence indices, and inflation rates.
By considering a range of economic indicators, traders and investors can better understand the economy and make more informed decisions about business and investment strategies.
How can the ISM manufacturing index be used in backtesting investment strategies?
One application of the ISM Manufacturing Index in backtesting is as a predictor of economic conditions.
Another way to use the ISM Manufacturing Index in backtesting is to evaluate the effectiveness of investment strategies based on economic indicators.
For example, an investment strategy that involves buying stocks when the ISM Manufacturing Index is above 50 and selling when it falls below 50 could be tested by applying it to historical data and comparing the results to a benchmark such as the S&P 500. We did such backtests later down in the article.
What are some common trading strategies that incorporate the ISM manufacturing index?
These are some of them:
- Fundamental analysis-based strategies: This strategy involves analyzing the underlying factors that can affect the demand for a particular asset, such as economic indicators like the ISM manufacturing index.
- Momentum trading: This strategy involves buying an asset that is experiencing upward momentum and selling an asset that is experiencing downward momentum. The release of the PMI data can spur an upward momentum if the data is better than expected and a downward momentum if the data is below expectation.
- Trend following: This strategy involves buying an asset that is trending upwards and selling an asset that is trending downwards.
- Mean reversion: This strategy involves buying or selling an asset when its price moves away from its historical average, with the expectation that it will eventually return to its mean.
- Contrarian investing: This strategy involves going against the crowd and buying assets that are out of favor or selling popular assets.
How can the ISM manufacturing index be used to inform investment decisions in the manufacturing sector?
The ISM manufacturing index can be used to inform investment decisions in the manufacturing sector by providing insight into the industry’s health and outlook. If the index rises, it could mean that the manufacturing sector is expanding, which is good news for manufacturers and their suppliers.
If, on the other hand, the index falls, it could be a sign of slowing demand or other issues confronting the sector, which could be detrimental to manufacturers and their suppliers. Investors can use the ISM manufacturing index, along with other economic indicators and company-specific data, to inform their manufacturing investment decisions.
Can the ISM manufacturing index be used to develop investment systems for actively managed portfolios?
Yes. Since the PMI is closely watched by manufacturers and retailers to determine the health of the manufacturing sector, it can be used to develop investment strategies for portfolios that include stocks of manufacturing companies, as the index’s data can have a significant impact on the returns of its prices.
How does the ISM manufacturing index compare to other economic indicators in terms of predicting stock market performance in the manufacturing sector?
Many investors consider the PMI to be a leading indicator of GDP growth or decline. Individual PMI components can also be useful in markets.
The bond markets keep a close eye on the increase in supplier deliveries and prices paid. These figures can shed light on the possibility of inflation. Bonds are fixed-income assets, so inflation hurts their prices. Investors interested in specific industries may also examine purchasing trends within vertical markets.
Can the ISM manufacturing index be used to create passive investment strategies, such as index funds?
Yes! You can use the ISM manufacturing index to create a passive investment strategy if you invest in an index of stocks of companies that perform better when the manufacturing sector is growing.
How has the ISM manufacturing index performed as a predictor of economic conditions in the past?
Source: TradingEconomics
From the above chart, we can see that a decreasing PMI negatively impacts the GDP growth rate, as businesses in the manufacturing line tend to have lower demands. The opposite is also true.
Furthermore, a consistent decline in PMI may be a hint of recession as seen in the COVID-19-dominated 2020.
Can the ISM manufacturing index be used to identify potential market trends and shifts in the manufacturing industry?
Yes! The ISM manufacturing index shows the well-being of the manufacturing sector, a sustained decline in the indicator reading could indicate a bear market or recession. Conversely, sustained growth of the indicator could mean that the economy is picking up.
How can the ISM manufacturing index be combined with other economic indicators to create a more comprehensive view of economic conditions?
The PMI can be used in conjunction with other economic indicators to better gauge the economic outlook of a country.
For example, investors may look at the employment data and PMI together. A falling PMI with an increasing number of jobless claims could mean that business is not moving.
Another usage is following inflation data, consumer spending, and PMI to gauge the overall direction of the economy.
How does the ISM manufacturing index impact the outlook for businesses in the manufacturing sector?
A high reading on the index may indicate that demand for manufactured goods is high, prompting businesses in the sector to increase production and potentially hire more workers.
A low reading on the index, on the other hand, could indicate that demand for manufactured goods is slowing, prompting businesses to reduce production and potentially lay off workers.
Overall, the ISM Manufacturing Index can provide useful insight into the current state and future outlook of the manufacturing sector, and businesses in the sector should monitor its movements closely.
Where can I download PMI data?
You can download data from their homepage.
Alternatively, we have a Google Sheet that you can use that contains data back to 1970:
What does PMI mean in the stock market? Backtest
Does the ISM (PMI) Manufacturing Index predict the stock market well?
Let’s examine if the ISM Manufacturing Index has any predictive value for the stock market.
The numbers published at the beginning of every month refer to the prior month. Thus, the numbers presented on the 1st of February refer to the economic activity in January and so forth. This is a heads up if you want to backtest and you need to adjust the tables. It’s not an indicator for short-term trading.
Also, the stock market is always forward-looking. Thus, when the numbers are revealed at the beginning of the month, the numbers might already be discounted as “yesterday’s news”.
ISM (PMI) Manufacturing Index backtest no 1
Readings above 50 indicate manufacturing sector expansion, and below 50 indicate manufacturing sector contraction. Let’s make the following trading rules based on this:
Trading Rules
THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES
CLICK HERE TO SEE ALL 350 ARTICLES WITH TRADING RULES
The equity curve looks like this:
The strategy is invested 72% of the time, and the annual return is 7.3% (compared to 8.5% for S&P 500). Thus, most of the gains have come when readings are above 50, but it has also reduced drawdowns.
This also means that low readings below 50 have proven mediocre – even adjusted for time spent in the market.
Let’s backtest to see what happens if we hold for a longer time period:
The table below shows when we have readings above 50, and we hold S&P 500 for N-months (see column one):
For example, if we hold for 12 months, the average gain per trade is 10.99% and we are invested 86% of the time (see last column called “exposure”).
ISM (PMI) Manufacturing Index backtest no 2
Let’s look at the gold price. We backtested many asset classes, and the only asset that works better with low ISM readings is gold.
The table below shows the results when we have readings below 50 and the subsequent returns N-months forward:
ISM Manufacturing Index PMI – Conclusion
As far as we can see, our backtests show that the ISM manufacturing Index is not a particularly good contrarian indicator, despite positive (anecdotal) proof on social media. We follow the numbers. The main reason for the lack of contrarian movements is probably because ISM is a lagging indicator. The numbers are already discounted by markets by the time they are published.
List of trading strategies
We have written over 1200 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation. The code we have used in this post is included.
The strategies are taken from our landing page of EOD strategies.
The strategies also come with logic in plain English (plain English is for Python trading and backtesting).
For a list of the strategies we have made, please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
FAQ – Manufacturing Index
Let’s end the article with a few frequently asked questions:
When is ISM Manufacturing Index PMI published?
The MSM Manufacturing Index is published at the beginning of every month.
Is ISM Manufacturing Index a leading indicator?
It’s a leading indicator in the sense that it’s based on surveys, and it might “lead” the real economy. However, the stock market is always forward-looking and any good or bad readings might already have been discounted in the stock market.
What is the ISM Manufacturing Index?
The ISM manufacturing index, also known as the purchasing managers’ index (PMI), is a monthly indicator of economic activity in the US based on a survey of purchasing managers at over 300 manufacturing firms. It is considered to be a key indicator of the state of the US economy because it measures the change in production levels across the US economy and indicates the level of demand for products by measuring the amount of ordering activity at the nation’s factories.
The PMI is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories, and each factor is seasonally adjusted. The PMI is released on the first business day of each month, and a reading above 50 indicates an expansion in the manufacturing sector of the economy compared to the previous month, while a reading of 50 indicates no change and a reading below 50 suggests a contraction. The PMI is widely watched by investors and businesses because it can greatly influence investor and business confidence and can provide insights into national economic trends and conditions.
How is the ISM manufacturing index calculated?
The ISM manufacturing index is calculated based on a survey of purchasing managers at over 300 manufacturing firms in the US. The survey measures the change in production levels across the US economy, as well as the level of demand for products by measuring the amount of ordering activity at the nation’s factories. The survey is used to compile a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories. Each factor is seasonally adjusted to account for variations in demand due to the time of year.
What is the significance of a reading above 50 on the PMI?
A reading above 50 on the PMI indicates an expansion in the manufacturing sector of the economy compared to the previous month. This suggests that there is an increase in production levels and demand for products, which can be seen as a positive sign for the overall economy. A reading of 50 indicates no change, while a reading below 50 suggests a contraction in the manufacturing sector.
How is the PMI used by investors and businesses?
The PMI is widely watched by investors and businesses because it can greatly influence investor and business confidence and can provide insights into national economic trends and conditions. Investors and businesses may use the PMI to inform their decision-making and assess the health of the economy.
Can the PMI be used to develop trading strategies?
The PMI may be used as one factor in developing trading strategies. It is important to consider the PMI in conjunction with other economic indicators and market conditions to get a comprehensive understanding of the market.
How accurate is the PMI in predicting economic activity?
The PMI is considered to be a reliable indicator of economic activity, but it is not necessarily always accurate in predicting future economic conditions. It is one of several indicators that can be used to assess economic conditions, and should be considered in conjunction with other indicators for a more comprehensive understanding of the economy.
How does the PMI compare to other economic indicators in terms of reliability?
The PMI is considered to be a reliable economic indicator, but it is not the only indicator of economic activity. Other indicators, such as GDP and unemployment rates, can also provide valuable insights into the health of the economy. It is important to consider a variety of indicators to get a comprehensive understanding of economic conditions.
Can the PMI be used as a leading indicator of economic conditions?
The PMI can be used as a leading indicator of economic conditions because it measures current economic activity and can provide insights into future economic conditions. However, it is important to consider the PMI in conjunction with other indicators to get a more comprehensive understanding of the economy.
How does the PMI take into account seasonal adjustments?
The PMI takes into account seasonal adjustments by adjusting each of the factors that make up the index for variations in demand due to the time of year. This helps to provide a more accurate picture of economic activity by removing the influence of seasonal factors.
How is the weighting of the various factors that make up the PMI determined?
The weighting of the various factors that make up the PMI is determined by giving equal weight to each factor. This helps to ensure that each factor has an equal influence on the overall index.
Can the PMI be used in conjunction with other economic indicators for a more comprehensive understanding of economic conditions?
Yes, the PMI can be used in conjunction with other economic indicators to get a more comprehensive understanding of economic conditions. It is important to consider a variety of indicators to get a well-rounded view of the economy. Other economic indicators that may be considered in conjunction with the PMI include GDP, unemployment rates, inflation, and consumer spending. By considering a range of indicators, investors and businesses can get a more complete picture of the economic conditions and make informed decisions.