Lots of people are still talking about yesterday’s ugly ISM report, which showed a big contraction in the overall outlook, prices paid, and new sales.
Because the drop was so startling, there’s been a ton of talk about whether we’re going into another deflationary recession, or something nasty like that.
We’re not going to speculate on that here, but we thought it was important for everyone to realise what the ISM is, and what it’s measuring.
As you might (or might not) know, an ISM reading of 50 means “no change” from the previous month, whereas an ISM above 50 signifies improvement, and a sub-50 ISM signifies worsening conditions.
So how does the ISM determine whether the survey respondents are doing worse or better? They just ask the companies: Are you doing better or worse? Are you hiring more people or less people? Are prices higher or lower?
Wikipedia explains how they’re tabulated…
INDEX = (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.
Thus, if 100% of the panel reported an improvement the index would be 100.0. If 100% reported a deterioration the index would be zero. If 100% of the panel saw no change the index would be 50.0 (P2 * 0.5).
Therefore, an index reading of 50.0 means that the variable is unchanged, a number over 50.0 indicates an improvement while anything below 50.0 suggests a decline. The further away from 50.0 the index is, the stronger the change over the month. E.g. a reading of 55.0 points to a stronger increase in a variable than a reading of 52.5.
So in light of this, let’s look at the prices paid index from yesterday’s ISM.
This is the component of the index that where the survey asks respondents whether input costs (like raw materials) are going up in cost.
As you can see, there was a HUGE drop in the month, from over 60 in the month before, to under 40.
On a percentage basis, that’s over a 33% drop, but it does not mean that input prices fell around 33%. This is where people get tripped up.
If the vast majority of respondents saw an incredibly tiny drop in input costs (say less than 1% across the board) you could still see a huge drop in the index.
So the index is measuring breadth of the sentiment. It’s not measuring price changes. It’s not measuring sales changes or anything. It’s just gauging the breadth of respondents sense about whatever category is being asked. So a huge drop doesn’t necessarily mean a huge drop in actual business.