Cycles in ISM PMI

I would like to share some ideas that I have been following for a while and lately modelled developed myself on the cyclical nature of oscillations in the Purchasing Managers' Index, measured and published by the Institute of Supply Management in the US. While this will be the main point of the post, I will briefly give some background to the study of cycles in Economic activity.

It is of course known that the business cycle influences just about everything in the economy. Mainstream economics primarily focuses on inventory cycles and frequently accompanying cycles in monetary policy. These usually last no longer than 3-5 years. However, mainstream economics tends to ignore fairly apparent cycles that span decades. Brian Berry described and analysed roughly 30 year cycles in US economic activity, centred around infrastructure investments and capital stock replacement. For more information, please refer to his brilliant book (Long-wave Rhythms in Economic Development and Political Behaviour, 1991). In the future, I will aim to write up a brief introduction into his work and illustrate with examples by analysing roughly 30 year cycles in US Industrial Production (IP). For now, I will just say that there is some evidence that a 30 year Berry cycle finished with a collapse in US IP into June 2009. A new 30 year Berry cycle has thus likely begun, and will be most similar (again, for reasons which I will aim to elucidate in the future) to the 1921-1946 cycle. Note that the cycle that has just begun will be most similar to the one that spanned the Great Depression and the second World War. If this analysis is correct (and it was very useful to predict both the downswing in 2000, upswing in 2003 and the most recent collapse), then we can expect an early peak in US IP, likely around 2012, followed by bleak "teens".

Now on to the ISM PMI.

First, the charts. As mentioned above, I see US economic activity unfolding in cycles roughly 30 years in length. The most recent cycles are 1980-2009 and 1946-1980. These cycles are clearly evident in US IP data and in ISM figures (chart 1)

Chart 1: ISM PMI 1946-present

The chart presents two complete time series: ISM PMI levels from 1946 to 1980 in red and 1980 to 2008/9 in blue. Major peaks and troughs are clearly aligned. The last drop in the blue line came earlier than expected, but was well telegraphed by IP charts and other indicators. What is important now is that the very sharp rise in the index since December 2008 (shown in green on the far left of the chart - the third and incomplete time series) probably signals the start of the new cycle.

Interestingly, the cycles above can each be divided into three roughly equal (in time) parts, of about 10 years each. It makes most sense to compare like with like, so I will compare the 10 year cycles that began their respective 30 year cycles. However, comparing 10 year cycles that are in the middle of the longer cycle with each other or even with other 10 year cycles (placed elsewhere in the longer cycle) yields similar results - major peaks and troughs overlap.

Chart 2: ISM PMI (selected) 10 year cycles

Chart 2 shows three complete time series of ISM PMI: 1946-1958, 1980-1991 and 1991-2001. It also shows the incomplete cycle that began in December 2008. It is again clear that major peaks and troughs align across the cycles. What is of note is that cycles that begin their respective higher order (30 year) cycles, such as the 1946-1958 and 1980-1991 cycles experience deeper retracements to the initial surge off the cycle low, compared to the 1991-2001 cycle (which is in the middle of its higher-order 30 year cycle).

According to the cyclicality thus established and demonstrated, we can expect either protracted stalling of ISM PMI around current levels (basically, hovering around 50) for the next 12-15 months or, with higher probability, a rather deep retracement, possibly as far down as low 40s or high 30s. Needless to say, this will be a very big surprise to risk and related markets, which are priced for a rather ambitious 3.5% or so growth for 2010. Again, if the economy proceeds to develop along the lines that are typical, we should expect the ISM PMI to drop into late 2010, and then rise into mid 2012. After that, we should have anaemic "teens".

In summary, we can expect continuous weakness in the ISM PMI from now on, for at least 12 months.

I hope this was enjoyable, informative and clear.

If you have any questions, please write to me.

Thank you and have a great week,

Aidyn.