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David Tsao

What is the ISM Services Index? The report attempts to gauge how the service sector of the US economy is doing. For example, it will cover how the hotels and restaurants are doing as opposed to how Ford is doing. The Institute of Supply Chain Management sends out surveys every month to these businesses to answer a few simple questions. The survey isn’t just sent out to anyone, but directed towards the people who have the power to buy stuff and hire people. If you aggregate enough of this information you should be able to get a pretty good gauge of the service sector’s health.

What does the Non-Manufacturing Index try to measure? The index is really comprised of 4 components and tries to measure if the overall service sector is contracting, staying the same, or expanding. ISM just started doing the composite version of the formula in January 2008 to most likely get a better picture of everything. The 4 components are: - Business Activity (general business condition) - Employment (hiring more, freezing, and layoffs) - New Orders (are you buying more stuff, or less?) - Supplier Deliveries (how is fast are your suppliers delivering stuff?) In each of these components, the respondents must answer one of the following about what changed regarding a given set of criteria, the 3 answers to choose from being Better, Same, or Worse. Example:

What you end up with an allocation of answers into those 3 buckets for each of the 4 main components mentioned above. Each of the 4 components will have a series of questions. Let’s take the Employment category for example: Let’s say one of the questions was posed:

At first glance what does that look like? It’s more weighted on the worse side of the fence, so sentiment amongst purchasing executives in the service sector see employment activity worsening. The ISM then uses what is called a “diffusion index” to make the number easier to digest. When you go month to month, the breakdown amongst the 3 buckets will vary. It’s harder to gauge how bad or good something is doing. So using a “diffusion index” pretty much generates a single number to streamline it a bit. The formula takes the “Better” component and adds it to half of the “Same” component. So using the example we have above, the index value for this question would be: 6% + (70% divided by 2) = 41% Trying another scenario:

What does this look like now? It looks like nothing has changed really as 5% of respondents think things are getting better, and 5% think it’s getting worse. The remaining 90% see nothing changing. Running this through the formula you get: 5% + (90% divided by 2) = 50% And that’s the simple beauty of a “diffusion index”. 50% means nothing changed. If the number dips below 50%, the survey respondents overall think things will move in the “worse” direction. If the number moves above 50% then overall sentiment moves towards the “better” direction. So what ISM does is average out all these index values for all the questions in the survey and adjusts it for seasonality changes. The resulting Employee Activity index value for January was 43.9%. The overall measure is to equally weight the 4 components (just average them out). This is what you get:

Companies to focus on The ISM Services Index report highlights educational services sector growth or contraction, providing insight into companies such as DeVry (DV), Strayer (STRA), Apollo (APOL), and Career Education (CECO).