Money Flow Index – How Does it Work and How to Use it?
Trading guides, webinars and stories
Trading guides, webinars and stories
The market pays a great deal of attention to the Purchasing Managers’ Index. It’s an indicator that can potentially determine the very direction of the market. That puts it in the same league as macroeconomic data by national & international statistical bureaus. This begs the question of why these stats are so significant and exactly how reliable they are.
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The figure itself is a derivative of a statistical survey result. It’s based on the hundreds, if not thousands of questionnaires sent to the purchasing managers of various companies. This process is reminiscent of classic social research methodology, not unlike exit polls during elections for example. It’s an empirical study where the researchers aim to make the results representative. To do that, it categorizes the data by country, sector and company size. Afterwards they randomly select the companies to send the questionnaires to.
The survey questions typically fall into 8-10 main categories. These include changes in new orders, production output, number of unfilled positions, future hiring prospects and of course the acquisition of resources for their operation. Managers can mark the degrees of change on a scale for each respective category. The result is a simple number that one can easily weigh. It’s widely used by researchers and institutes, each with their own formulas, to calculate the final PMI figure. The calculation process illustrates how dynamic the PMI index really is. It combines both an evaluation of the current state of affairs as well as the potential future outlook. The strict research methodology and large sample size make it as objective as any official public opinion poll. That’s why the market generally considers it credible data.
The statistics compiled by most other governmental and administrative bodies are generally based on past data with a possible delay of 1-2 months. The PMI’s main advantage is that it gives some inference to the future. That is an invaluable feature in the eyes of traders and investors.
The largest PMI research institutes are the US based Institute for Supply Management and the international IHS Markit. Both of them examine a variety of developed markets and use fairly similar research methods, making them easy to compare. They typically use three sub-indices: the more general Composite Index, the Manufacturing Index and the Service PMI. The importance of these three varies from country to country, however, for stock traders this type of division significantly helps them evaluate the content of their portfolios.
This brings us to why investors consider the PMI so significant. Take for example a mutual fund with a stock portfolio containing several hundred individual elements, diversified both in sector and region. The portfolio manager’s goal is to beat the benchmark and have higher yields than the key stock indices.
When the German manufacturing PMI falls below 50 points, it suggests the growth of German companies could slow down. In this case the portfolio manager may decide to reduce their exposure in that area by selling. Not only will they sell, but they’ll do it as soon as possible to protect their previous earnings and avoid potential losses. Rather than wait for their stocks to drop, it’s safer to get rid of a risky asset sooner. The result is often a strong selling pressure for the respective stocks & indices. Speculators are also keenly aware of the kind of reactions a low PMI can trigger. So, they tend to place short positions in an attempt to ride the wave.
That’s the theory, but does it work in practice? Like any other indicator the Purchasing Managers’ Index isn’t infallible either and is only one of many factors that influences these decisions.
China’ Caixin PMI released on the first of April was at 50.8 points. That’s a 0.9 point increase from the previous month and exceeded expectations by 0.6 points. Following the announcement the Shanghai Composite Index rose from 3090 to 3154 points, since the positive outlook led to new buy positions being opened.
Meanwhile the Markit Manufacturing PMI was released in Germany on the very same day. It was at 44.1 points, meaning 4.8 lower than last month and 0.6 points below expectations. It’s natural to assume that the German DAX index would decline sharply as a result, however, that’s not what happened. It doesn’t matter how terrible the Purchasing Managers’ Index results are if investors have already gotten rid of their stocks. The German index has been under performing for the past year so. That means investors have already priced in the constant stream of bad news. As a result, a single poor report didn’t worsen the established negative view of the German economy.
On the other hand the optimism from China’s positive Purchasing Managers’ Index was infectious enough to give investors hope that the German economy could recover as well. By the end of the day both the DAX and the Asian indices closed with a significant increase.
A single point of data isn’t necessarily indicative of a larger trend. Looking at the big picture helps protect us from losing sight and falling into a false conception trap.