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People worried about a recession in the US are particularly focused on the ISM manufacturing index, which has been in contraction territory for the past few months.

But the ISM index is bad at predicting downturns in the economy and typically overstates weakness in the manufacturing sector.

The ISM is also out of step with other strong economic indicators.

Neil Dutta is head of economics at Renaissance Macro Research.

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Economic worrywarts keep finding new reasons to get nervous about the US economy. First, it was the weakness in the housing market. Next it was the inversion of the Treasury yield curve. Now the favorite data of recession worriers is the ISM Manufacturing PMI.

The ISM index is a survey-based measure that asks about 300 purchasing managers across the manufacturing sector whether activity is up, down, or flat relative to the prior month. A reading above 50 in the index indicates that the sector is expanding, while a reading below 50 indicates a contracting manufacturing industry.

Since March, the index has declined from 55.3 to 48.3, and below 50 for the past three months, triggering worries about an economic downturn or even a recession.

As with every previous freak-out, the economic pessimists are mostly focusing on a single data point while missing the bigger picture of continued economic growth.

The ISM is bad for gauging the market

As the recent downward move picked up, the ISM manufacturing index began to garner more and more attention. A simple query in Google Trends shows search interest spiking following a disappointing September reading.

While the public’s attention is recent, the ISM has an almost mythical reputation in the financial markets, spawning a cottage industry of market-timing models based on its direction. But the ISM’s usefulness for evaluating the markets is dramatically oversold.

The ISM, like the financial markets, can be thought of as a growth-momentum barometer. As a result, financial market indicators go a long way to explaining the ups and downs in the ISM.

Consider a simple four-variable model that uses the S&P 500, 10-year Treasury-note yields, corporate-bond spreads, and the broad USD exchange rate to estimate the ISM. What do we find? Together, these four variables explain about two-thirds of the variance in the ISM.

Shayanne Gal/Business Insider

But if financial markets explain a good deal of the movement in the ISM, then it seems pretty risky to be using the ISM to make sweeping market calls to begin with.

This is the rough equivalent of saying „I am bearish on the US stock market because the market has been declining“ — akin to a second-rate form of technical analysis, a forecast for the market based largely on the assumption that the market is usually just reacting to itself with declines begetting even more declines.

To the extent that a market-timing model using the ISM works, it really does so only at the extremes, when the index is especially low, or especially high. In the middle, the ISM signal for stocks is mostly just noise.

The ISM is a bad economic indicator

While the ISM is a flawed market-timing tool, it is almost as bad as an indicator of economic cycle timing. The ISM index sent as many false signals, defined as a dip below 50 into „contractionary“ territory, as correct ones.

There have been two recessions in the past 20 years, and these recessions have been preceded by 10 distinct peaks in the ISM and as many drops below 50.

Before the most recent readings, the ISM manufacturing index dipped below 50 twice since 2010: in 2012 and 2015. Obviously, a recession did not follow either of these signals. In short, in the past few decades, we have seen several false signals for every correct one.

Moreover, while the ISM mirrors the broad movements in factory activity, it can often overshoot relative to actual activity both on the way up and on the way down. Based on a chart showing the ISM’s predicted manufacturing activity compared to actual manufacturing activity growth, we can see that the ISM follows production fairly closely but that there are notable periods where it overshoots.

growth in us industrial production vs ISM manufacturing index chart Shayanne Gal/Business Insider

From 2017 to 2018, as an example, the ISM was consistent with annualized manufacturing growth of 6% to 7%. Actual growth was about half as strong.

Or how about 2008? The ISM was holding above its break-even mark of 50 even as actual factory production was collapsing.

More recently, it is important to highlight the fact that the ISM appears to be out of step with other survey-based measures of the US manufacturing industry.

Most notably, the Markit PMI, a survey with more than twice the sample size of ISM, recently improved to 51.3, its best level since April. The Markit measure has also been less volatile, tracking production more closely than ISM in 2017 and 2018. Similarly, regional manufacturing PMIs such as the New York Empire and Philly Fed have been holding up a bit better too.

While the decline in the ISM manufacturing index is troubling to some, we think they’re overselling their case. The ISM is a nice rough-and-ready indicator, but using it as the basis of an economic and market call is fraught with risk.