Supply Excellence — Caveat Emptor: Economic Indicies Could Be Misleading You

Caveat Emptor: Economic Indicies Could Be Misleading You

November 30th, 2006 · by Tim Minahan · No Comments · best practices, supply management

The recent Supply Excellence exclusive with Norbert Ore, Chair of the Institute for Supply Management’s (ISM) Manufacturing Business Survey Committee, prompted some lively commentary questioning the accuracy and value of economic indicators. The most vocal commentator was Charles Dominick, president and founder of Next Level Purchasing and author of the Purchasing Certification Blog.

I have admired Charles’ focus on advancing supply management skills and have become a regular reader of his blog. (Charles and I even collaborated on a podcast on the future of supply management technology, which you can still download here.) So I felt it would be valuable to get Charles’ experienced advice on how (and if) supply managers can leverage economic indicators, like the ISM Index, to aid their sourcing and supplier management strategies.

Below is the first of a two-part interview I did with Charles on the subject.

Supply Excellence (SE): You recently made a very pointed argument that professionals need to use caution when making decisions based on economic indices. Can you elaborate on your thoughts?

Absolutely. Here are a few points I’d like to make:

Just because an organization publishes what it considers to be an economic indicator doesn’t mean that it is accurate or valid. There are good economic indices and there are poor ones, too.
When contemplating using an economic index, you really need to understand some fundamental things about indices.
When contemplating using an economic index, you really need to understand how the index is calculated to evaluate its value.

SE: What are some of the fundamental things that a professional should know about economic indices?

Most indexes publish a number that is associated with a certain date. You need to know what that number means. The number will mean something different depending on the index. An indicator like Gross Domestic Product (GDP) is expressed in money. An indicator like the Consumer Price Index (CPI) is expressed as a number that is calculated to represent change from a fixed point in time, so the baseline never changes. The Purchasing Manager’s Index (PMI) is expressed as a number that is calculated to represent change from the previous month, so the baseline changes with every publication of the index.

SE: How do you estimate the validity of an index?

I always suggest comparing different relied-upon indices and look for consistencies and inconsistencies.

SE: Does the fact that the way the numbers are calculated pose a challenge for comparing indices?

It can. For example, the PMI had a value of 56.3 in January 2005. In July 2006, it had a value of 54.7. At a quick glance, one may think that this represented an economic decline. But that’s not the case. The PMI is calculated such that a value of 50 means no change from the previous month, a value over 50 indicates growth from the previous month, and the baseline changes monthly.

So, to compare this index against other indices, this requires the conversion of the PMI to a fixed baseline by assigning a value (e.g., 100) to the first month to be compared and, for each month, calculating the percent change from 50 (not from the previous month’s value), and adding that percent change to the previous month’s adjusted value to determine the current month’s value.

So while the PMI’s values alone might be graphed out like this (and therefore not showing growth)…

(click to enlarge image)

…the fact is that the value has exceeded 50 every month during the period in review and indicates continual monthly growth. Converted to a fixed baseline, the PMI would look like this:

(click to enlarge image)

When evaluating consistencies and inconsistencies between indices, it is helpful to set them all to a base value of 100 for the starting date and assign a number for each month based on a percentage delta between the date and the starting date. For example, let’s use the stock market index, the S&P 500. The closing value of that index was 1181.27 on the first trading day of January 2005 and 1203.60 on the first trading day of February 2005. This means that the value was 1.9% higher in February [ (1203.60 – 1181.27) / 1181.27 = 0.019].

So you would assign the S&P 500 index a value of 100 for January 2005 and 101.9 for February 2005. You would do this for each month to show the percentage difference between that month’s value and the baseline value. You would do the same for the other indices that you want to compare. Then you chart the values as follows:

(click to enlarge image)

As you can see, there is a lot of consistency in these indicators. One may surmise that in this 18-month period, we’ve seen economic growth in the 3-8% range.

SE: You’ve expressed concern over the PMI. Why?

I have a great deal of respect for the organization that publishes the PMI and don’t have any issues with the PMI whatsoever. What I do have concerns about is the way that people use and interpret it. I personally do not feel that it is an economic indicator as strong as the others out there. When you convert the PMI in the same manner as I had with the other indicators in order to put it on a comparable, level playing field, you would see these results:

(click to enlarge image)

So while I think that some of the text that accompanies the publication of the PMI (e.g., “Commodities in Short Supply”) can be helpful to supply managers, I think that the numbers should be interpreted with extremen caution. Unfortunately, I am observing that analysts and media are focusing primarily on the numbers without truly understanding them.

Thanks for the tutorial Charles. Your insights really help put the value of economic indicies in perspective. They also reinforce the age-old phrase, “There are three kinds of lies: lies, damned lies, and statistics.” Figures, whether economic indicators or supplier performance metrics, are only as good as their assumptions and formulas. Supply managers must ensure both are accurate before building a sourcing or supply strategy upon them.

Check back here for Part Two of this interview, when Charles shares his tips on assessing commodity markets and his favorite sources for supply market information. Charles also provides his predictions for the future of supply markets.

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