In Uncategorized on August 22, 2009 at 10:48


Understanding leading indicators

There is no shortage of economic releases on regular news outlets each day, but not all economic data is of equal value in discerning the future trajectory of the economy. The most useful economic indicators for identifying turning points in an economic cycle are considered “leading” indicators because they tend to identify emerging trends. For instance, housing permits are a leading indicator of housing activity because builders must register for permits prior to beginning construction.

Other categories of indicators are generally less useful to investors because they tend to describe what is happening currently (coincident), or detail what has already transpired (lagging). In addition, many leading economic indicators tend to be reported in a more timely manner, while reporting lags make other indicator data much less useful for forecasting the direction of the economy.

The record in predicting recoveries

Large swings in the direction of leading indicators historically have been helpful in identifying turns in economic cycles, from expansion to recession and recession to recovery. A well-recognized group of leading indicators are the 10 sub-components of the Conference Board’s Leading Economic Index (LEI), which include data from a wide variety of sectors in the economy, such as consumer expectations, manufacturing and the financial markets.1

While these 10 individual indicators do not necessarily measure the magnitude of an upcoming rebound or downturn, when they all move in a sustained manner in one direction they often portend the general trajectory of the economy. For instance, for every recession since 1958, the percentage of leading indicators within the LEI that rose during the previous six-month period declined to 20% or lower (two or fewer out of 10 indicators rising). In contrast, at least 90% of the indicators rose in anticipation or concurrently with each subsequent economic recovery (see Exhibit 1).

Thus, after reaching recessionary levels, sustained multi-month upward movement in leading economic indicators has historically presaged or accompanied an economic rebound. Because stock markets tend to anticipate recoveries, early signs of upward movements in leading indicators often have accompanied stock market rallies, with most gains typically occurring before all leading indicators had moved directionally upward.

Current update on leading indicators—positive (though currently less useful) indicators

While most leading indicators turned dramatically negative in late 2008, two monetary indicators have been in positive territory for quite some time—the money supply and yield curve. Both of these indicators are evidence of significant U.S. government policy responses trying to combat deleveraging in the financial system, to repair the poor state of banks’ balance sheets, and to stave off the threat of deflation. However, due to the extraordinary nature of the financial crisis, during the past year these indicators have failed to predict an economic upturn.

The Federal Reserve began to lower its target short-term interest rate in the fall of 2007, followed by a series of cuts that left the target rate near 0% in mid December 2008.2 This action steepened the yield curve (short-term interest rates lower than long-term rates). Typically, a steep yield curve allows banks to become more profitable and spark a recovery in lending (banks borrow funds at short-term rates and lend them to businesses and consumers at higher long-term rates). In addition, the Fed launched a number of initiatives and quantitative easing programs that have increased the money supply.

Increases in money supply have historically provided a boost to financial activity with knock-on effects for the economy. In this economic cycle, however, these positive factors have been overwhelmed by the credit crisis, caused by the extraordinary damage done to the balance sheets of financial firms as a result of massive losses on mortgage-related and other securities. So while a steep yield curve and rising money supply have helped stabilize the financial system from its crisis level several months ago, they have yet to spur a broad-based economic recovery.

The current circumstances—the aftermath of the worst financial crisis since the Great Depression—are a reminder that leading indicators, like all economic data, are not foolproof. No two recessions are exactly alike, and thus no single indicator will ever be able to accurately forecast every possible economic scenario. For this reason, it is important for investors to watch for several indicators moving in the same direction (see Exhibit 2 for an update on leading indicators).

Recently positive (though volatile) indicators

The U.S. stock market is thought of as a leading indicator because it reflects business and investor confidence, in addition to other market factors. The stock market rallied more than 30% during the two months after it set a new cyclical low on March 9, 2009, a sharp turnaround from the bear market that began toward the end of 2007.3 Part of the impetus for the rally was investor reaction to better-than-expected economic reports in March and April.

However, stock price fluctuations can occur for a myriad of other reasons that are unrelated to economic conditions (including geopolitical events, disease, catastrophic weather events, terrorism, etc.). This is a reminder of a common pitfall of the stock market and other leading indicators—their volatility. Week-to-week or month-to-month fluctuations in data may be caused by statistical noise or unrelated factors, which is why it is important to focus on underlying trends.

Improving (though still not out of the woods) indicators

The most significant trend so far in the spring of 2009 is that the pace of decline has moderated for a handful of leading indicators that were severely negative in late 2008 and early 2009. In some cases, these indicators point to stabilization, in other cases they simply show that the rapid deterioration in the economy has moderated. Taken together, however, they have provided hope that the worst part of the economic recession may be in the past, and that the economy may stabilize earlier than expected.

An example of a leading indicator that has improved is initial unemployment claims (see previously released MARE article, Understanding Economic Indicators: Unemployment, for more detail on initial unemployment claims). Though the nation’s overall (aggregate) unemployment rate tends to garner more news headlines, the number of people filing for initial unemployment insurance claims is a good proxy for layoffs, and new claims tend to be a leading economic indicator for the direction of the labor markets (as well as the unemployment rate itself, which is a lagging indicator).

Historically, a slowing pace of layoffs has generally preceded a bottoming in the overall economy. During the past month or so, while high unemployment claims demonstrated that workers continue to lose jobs, the number of initial jobless claims has trended down.

Other leading indicators have followed a similar pattern, indicating economic weakness but showing a moderating pace of decline from late 2008 and early 2009. For example, while the absolute rate of newly issued housing permits hit an all-time monthly low level in March 2009, the rate of decline in building permits has slowed considerably in recent months. This slower rate of decline is potentially a sign of stabilization in home building conditions and housing markets.

Similarly, in March 2009 manufacturer’s new orders for non-defense capital goods—a proxy for overall business investment activity—nudged up for the second month in a row after hitting its lowest level since 1993 earlier in January. Consumer expectations, a leading indicator of consumer activity, rebounded sharply in April compared to the past several months (though it remained at a low level on a historical basis). Although all of these indicators still point toward continued economic weakness, their relative improvement from previous months provided support for the notion that the worst of the economic downturn may be over.

Investment implications

The early stages of an economic recovery are usually marked by violent fits and starts. A close examination of leading economic indicators shows that while some remain negative, others have either improved or their rate of deterioration has slowed. While these incipient signs of stabilization helped fuel the recent stock market rally, investors will be looking for sustained improvement in these indicators to confirm a bottoming of the economy.

Of course, there are no guarantees regarding the timing or the magnitude of any potential economic recovery, but historical analysis of leading indicators shows that owning stocks in the early stage of an economic upturn often has led to favorable results. What’s more, investors should be wary of waiting for all indicators to turn positive because this “all systems go” signal has usually occurred at or beyond the end of recessions, and after a considerable percentage of a bull market’s gains have been recorded (see related MARE article, U.S. Stocks Often Have Rebounded During Recessions).


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