What Is a Leading Indicator? What Is It Supposed to Predict?
A leading indicator is a published report, data set, or statistic that is used to help predict where we are in the economic cycle, and if a trend is changing.
Leading indicators are forward-looking, because they evidence the beginning of a shift, or a change in direction, before it is felt by the broader economy.
Lagging indicators are the opposite of leading indicators: They measure events that happened in the past.
Just like there is no crystal ball in finance, it must be noted that there is no single reliable metric to illustrate the state of the economy, and as such, policymakers, like the Federal Reserve, look at a variety of data in order to gain a complete understanding of what’s going on, and then use it to inform their monetary policy decisions going forward. Taken together, leading and lagging indicators can shed light on where we stand in the economic cycle—and also help investors position their portfolios for success.
What Are Some of the Most Important Leading Indicators? How Do They Forecast the Business Cycle?
If you keep a close eye on some of the most important leading indicators, you will get a good take on the economy in general. Any changes in these indicators, such as increases or decreases, often signal the beginning or the end of an economic cycle—and analysts watch these indicators with eagle eyes because they tend to shift before the cycle changes. Think of them like warning signals for the economy.
The following are a few (but not all) of the most important leading indicators.
The Yield Curve
Treasury securities are one of the most reliable investments; not only because they are backed by the “full faith and credit” of the U.S. government, and thus are virtually guaranteed never to default, but also because they are also a debt instrument that can be benchmarked. That means that they are easily comparable because all Treasuries have the same credit rating (AAA).
Every day, investors and analysts alike graphically plot the yields of U.S. Treasuries by interest rate and timeframe, or term, in order to produce the yield curve, which is a line that depicts the yields of all of the Treasuries.
Watching the yield curve can help investors understand where we are in the economic cycle. Normally, longer-term Treasuries offer higher yields to compensate investors for the risks they are taking in making such a lengthy loan. Sometimes, however, the yields between long-term and short-term Treasuries flatten, or become similar: This indicates a time of uncertainty in the economy, like investors anticipating interest rate hikes from the Federal Reserve or rising inflation.
And sometimes, short-term Treasuries—specifically the 2-Year Treasury—actually offer higher yields than longer-term Treasuries, specifically the 10-year Treasury. When this phenomenon happens, it’s known as an inverted yield curve.
But if investing is a matter of risk and reward, why take on more risk with a longer-term bond when a shorter-term Treasury, which inherently has less risk, offers a bigger payout? It doesn’t make sense for investors to take on more risk for less. So, yield curve inversion is commonly seen as an indicator of waning confidence in the economy—and many also believe it portends recession.
Initial Jobless Claims
The initial jobless claims statistic is published weekly by the U.S. Labor Department. It’s considered a good gauge of the labor market. Its tone also provides a good advance indication of the monthly Employment Situation Report, which plots employment trends and provides key data behind the unemployment rate.
So, when initial jobless claims rise, that signals a weakening economy and growing unemployment, and the stock market often reacts with volatility. Conversely, whennitial jobless claims fall, that means more workers have jobs and the economy is strong.
Purchasing Manufacturers Index (PMI)
Commonly known as the PMI and published monthly by the Institute for Supply Management, this report measures changes within all aspects of the manufacturing sector. For example, the report illustrates whether purchasing managers are placing more or fewer orders, where their inventory levels are at, what their rate of production is, as well as any changes with their employment levels or delivery schedule.
The PMI is measured on a scale of 1-100: Anything above 50 indicates expansion in the manufacturing sector, while levels below 50 show that it is contracting. By watching the PMI, analysts and investors are able to predict changes in quarterly GDP growth, because manufacturing makes up such a big slice of the overall pie: Manufacturing demand represents over 10% of US gross domestic product and a whopping 60% of its exports.
A building permit is effectively the “go ahead” from the government to start construction on a home. The building permits statistic, published monthly as part of the New Residential Construction report by the US Census and the Department of Housing and Urban Development (HUD), measures whether housing demand is growing, flat, or shrinking. After permits have been approved, builders begin construction, which is then counted in the housing starts statistic. Eventually all of this construction becomes a home, which gets accounted for in the New-Home Sales Report.
An increase in building permits predicts strength in the housing sector, which has a tremendous impact on the economy in general, and it can have a particular sway over the stock market. Building Permits may continue to rise even when there’s a bubble in housing, causing speculators to capitalize on the opportunity.
How Do You Measure Leading Indicators?
Analysts often use computer modeling and weighted averages of recent data to come up with the most accurate view of the economy as possible. However, it’s important to make sure you’re using actual leading indicators and not historical data in order to predict future trends; otherwise, you’re just retelling history.
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This story was originally published September 15, 2022 6:02 PM.
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