What are Leading Economic Indicators?
I am taking a break this week from the Investor Legend series. It will return next week. Instead, this week I am looking at leading, coincident and lagging economic indicators. If you have been reading the posts on this site, you have likely gathered that I enjoy trends and figuring out what the next big thing might be or where things generally are headed. This is why I find the topic of leading, coincident and lagging economic indicators quite interesting! The topic is not as confusing as it sounds. Economic indicators are simply indicators that provide information on the state of the overall economy. Leading economic indicators have turning points that precede changes in the economy and are valuable for forecasting where things are headed. Coincident economic indicators turn at relatively the same time as the economy and help describe the current state. Finally, no surprise, lagging indicators have turning points after that of the overall economy and identify what the economy was doing in the past.
Various countries use different combinations of indicators but in the United States, the leading indicator is the Index of Leading Economic Indicators (LEI). The Conference Board uses the following 10 different component parts to determine the LEI:
1. Average weekly hours, manufacturing – overtime hours will move up or down before the overall economy will. Why? Because businesses will cut overtime before laying people off and put workers on more overtime before hiring new people or re-hiring when the economy improves. Hence, a leading indicator of where the economy might be headed.
2. Average weekly initial claims for unemployment insurance – this provides a good sense of initial layoffs and rehiring before the general economy starts to move in a particular direction. Again, initial layoffs at that base level will precede the overall moves of the economy.
3. Manufacturer orders for consumer goods or materials – If the economy is looking up, consumers are demanding more goods and materials so orders will be up so this tells economists a great deal about where things are headed.
4. ISM new order index – This is similar to the above indicator, it looks at whether companies are increasing, decreasing or staying with status quo for new orders, production, supply chain, delivery, employment, etc. Again, these factors can foretell upcoming changes in the overall economy.
5. Manufacturers new orders for capital goods – this metric measures things a company might need to make products so measures its spending on things like small equipment, generators, computers, machinery. Again, if things are looking up, manufacturers are more likely to start spending on this sort of product.
6. Building permits for new houses – if applications for building permits are up, construction activity will also be looking up and this is a sign of the economy gathering strength.
7. S&P 500 Index – the movement of stock prices up and down can foretell economic cycles. Stock prices generally go up when the economy is looking promising.
8. Leading Credit Index – this measures the ability of the financial system to endure stress by measuring lending conditions. Favourable credit conditions are beneficial for companies and the economy. So favourable conditions in this regard can foretell a favourable upcoming economic situation.
9. Interest rate spread between 10-year treasury yields and overnight borrowing rates – Ok, granted this sounds confusing and it kind of is! The short version is to say that long term yields represent what interest rates will do in the short term. Short term rates follow the economic cycle up and down so a wider spread between these two suggests an economic upswing. The converse is true. We can leave this one to the economists to figure out!
10. Average consumer expectations for business and economic conditions – If consumers are optimistic, they start spending more and this can foretell an economic upswing. On the flip side, pessimistic consumers don’t spend as much and hold on to their money thus foretelling an economic downswing.
The Conference Board combines all of the above factors to determine a single figure known as the LEI. The variables typically turn downward before a recession and upward before an expansion. The LEI is generally seen as the best predictor of changes to the business cycles in the United States. You can find out about the LEI and other information like this on The Conference Board’s website.
An example of what a statement from The Conference Board on LEI looks like is as follows (courtesy of The Conference Board Press Release dated April 19, 2018):
NEW YORK, April 19, 2018...The The Conference Board Leading Economic Index® (LEI) for the U.S. increased 0.3 percent in March to 109.0 (2016 = 100), following a 0.7 percent increase in February, and a 0.8 percent increase in January.
“The U.S. LEI increased in March, and while the monthly gain is slower than in previous months, its six-month growth rate increased further and points to continued solid growth in the U.S. economy for the rest of the year,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The The Conference Board. “The strengths among the components of the leading index have been very widespread over the last six months. However, labor market components made negative contributions in March and bear watching in the near future.”
This is telling us there are slow gains being made in the overall economy but that the labor side of things are not growing. This merits further consideration in the future as they may be foretelling something different.
In addition to leading indicators, there are also coincident and lagging indicators. I won’t review those in any detail. One coincident indicator of interest is payroll. Once it is clear if the economy is on an upswing or downswing, companies will adjust full time payrolls accordingly. In terms of lagging indicators, inventory- sales is an interesting lagging indicator. This indicator makes intuitive sense in that inventories accumulate as a downturn takes effect and likewise, they are depleted as the upswing means more people and companies start buying again.
You are likely wondering what one does with the LEI once you decide to follow it or find it out online or in the newspaper? Well, it is meant to give interested individuals, including investors, a heads up on where things are going so you can make investment decisions. Typically, if the economy is going to grow and head into a busy time, stock prices will rise and vice versa. It helps give you a general idea where things might be headed so you can act appropriately.
Hopefully you learned a bit about the economy from this post and will perhaps start to pay attention to the LEI now?? If not, then these memes are for you:
** Top photo courtesy of Jason Leung on Unsplash