Lady Looking in Rear View Mirror - Lagging Economic Indicators

What drives your economic thinking?  What information contributes to your business decisions?  Or, your investment decisions?   I pose these questions because a great many people are influenced by recent events.  They let the past guide too much of their future by looking through the rear view mirror.  In fact, always looking backwards may only serve to increase your chances of becoming the victim of an accident.  So, why waste time learning about lagging economic indicators?

Take for example, how the average investor makes decisions when selecting mutual funds for their company retirement plan account.  Dalbar Inc. is an organization that performs research in this area.  According to Dalbar’s annual investor behavior studies , the average investor most often selects funds that were the prior year’s winners.  And, more often than not, in the following year, these past winners earn below average returns.  Even after several years of poor results, the average investor keeps chasing past performance.  This strategy keeps them in the same battle, fighting the same counterproductive war over and over.

Why Look Backwards?

Now I’m not saying that backward-looking information isn’t useful.  The Dalbar example was just an illustration.  Average investors may just be giving too little thought when making changes to their retirement plan selections.  Rather than taking more time to learn how to make better decisions, or seeking professional help.  They may just be giving short-shrift to the selection process and hope for the best.

Yet, I wouldn’t be surprised if this led you to think: Why waste my time learning about lagging economic indicators?  And, you may be right!  However, lagging indicators can provide a signal that a real trend has or hasn’t yet started.  And, this could be very important if those current and forward looking indicators are simply misleading.  Leading indicators are notorious for giving false signals.  If this were not so, you wouldn’t need to look at coincident and lagging indicators too!

Each month, various governmental agencies and research associations compile and release a wide variety of information about the economy.  Much of this data is “after the fact” information or relates to measures of confidence.  In addition, the data is created using statistical sampling methods.  These methods carry a margin of error.  Usually, the smaller the sample, the greater the potential for sampling error.  Yet despite their potential for error, these “economic indicators” can help guide our ability to make more confident financial decisions.  That is, if you take the time to understand them.

Helping you Understand the Economy

At Kaelber, Billmyer & Kaelber, LLC, we are committed to providing our clients and readers with every advantage when trying to preserve and grow their human, intellectual and financial wealth.  This article is the last in a three-part series that discusses some of the more widely followed economic indicators.  And, my goal was to bring context to their usefulness through summarizing them as: leading indicators, coincident indicators and lagging indicators.  My prior articles discussed “leading” and “coincident indicators” and this one will review “lagging indicators”.

Kaelber, Billmyer & Kaelber, LLC is a Charlottesville, Virginia CPA firm providing quality tax accounting, tax preparation & tax planning services for individuals, business, trusts & estates. We also offer business consulting services and private equity structuring support.

As the categories indicate, leading indicators help to predict what the economy will do in the future; coincident indicators help us understand the current state of the economy; and lagging indicators help to confirm or deny the validity of the other two.

The Lagging Economic Indicator Index Components

For the sake of efficiency and debate, I will describe these indicators in groupings used by The Conference Board.  The Conference Board is a global, independent research association who compiles data and publishes the indices of leading, coincident and lagging indicators each month.

The Conference Board combines seven economic measures into its lagging indicator model.  These measures are indicative of confirming the validity of economic trends.  The lagging index can also serve to signal the sustainability and momentum of an existing economic trend.  The following is a desription of each component indicator:

Consumer Health Measures

Average duration of unemployment.  Usually expressed in “number of weeks”, this is a measure of how long the average individual is unemployed.  While the sharpest increases seem to occur after a recession has started, decreases in unemployment generally occur only after a recovery or expansion phase gains strength.

Consumer credit outstanding to personal income.  This ratio measures the relationship between consumer debt and income.  Consumer installment credit is a statistic compiled by the Federal Reserve Board of Governors that measures the difference of new consumer credit less the repayment of principal on existing debt; and, the personal income data is the same employment related measure that I discussed in my article about Coincident Indicators – it is compiled by the Bureau of Economic Analysis.

The Conference Board contends that because consumers tend to hold off personal borrowing until months after a recession ends, this ratio typically bottoms after personal income has risen for a year or longer.

Business Health Measures

Inventory to sales ratio.  This measure uses inventory and sales data from manufacturing, wholesaling and retail businesses.  And, as used in the LEI, the numbers are adjusted for seasonal business cycles and for inflation.

Change in manufacturer’s labor costs per unit of output.  This is another business related measure that focuses on the manufacturing sector.  This ratio is erratic on a month-to-month basis.  So, The Conference Board “smoothes” over the data before including it in the index.  To smooth things over, they apply seasonal adjustments and recalculate the numbers over “rolling” six-month periods.

Commercial and industrial loans outstanding.  This measure reflects the trend of business only lending activity in the economy.   The majority of these loans are usually short-term in nature and tied to some form of collateral.  This series measures business loans held by banks plus the amount of commercial paper issued by non-financial companies as published by the Federal Reserve Board of Governors.

Business Health Measure Comments

The inventory to sales ratio can be very telling.  When an economy begins to slow down, what do you think happens to sales figures?  You’d expect sales to slow also, wouldn’t you?  And, if sales are slowing before manufacturers and purchasing managers find out, inventories should begin to build up.  As a result, it’s not unreasonable to see this ratio peak by the time we’ve reached the middle of a recession.  Alternatively, you should be able to observe a big decline in this ratio at the beginning of an expansion.  Why?  Because, inventory replenishment is not occuring fast enough to meet the newly increased demand.

In a recession, labor costs per unit should increase as production is scaled back faster than workers are being laid off.  The Conference Board’s literature provides this example.  Yet, unit labor costs could also rise as a result of a number of factors – including wage inflation.

The Conference Board’s rationale for the commercial and industrial loans outstanding index  is that the measure tends to peak after an expansion.  It peaks because declining profits usually increase the demand for loans.  And, it typically bottoms more than a year after a recession ends.

Measures That Impact Both Consumers and Business

Average prime rate charged by banks.  The prime rate is one of several short term interest rates.  Banks use the prime rate to price business loans.  As implied, a majority of the largest U.S chartered and insured commercial banks post this rate.  From this, the prime rate is an averaged.  Then, this statistic compiled daily.  Then, the Federal Reserve Board of Governors comiles the measurement used in the LEI index monthly.

This, perhaps, might be one of the most lagging numbers in the LEI index for one reason.  The U.S. Prime Rate is influenced by the Fed Funds Target Rate.  The Federal Reserve’s Open Market Committee sets the Fed Funds Target Rate.  It is potentially the most lagging indicator as the Fed doesn’t usually change the target rate unless it wants to take significant steps to either slow down or stimulate growth in the economy.  This factor aside, the Prime Rate has commonly been 3 percentage points higher than the Fed Funds Target Rate

Change in Consumer Price Index (CPI) for Services.  The Bureau of Labor Statistics compiles this change in the service component of the CPI.  The Conference Board asserts that it is probable that because of recognition lags and other market rigidities, service sector inflation tends to increase in the initial months of a recession and decrease in the initial months of an expansion.

Which Lagging Economic Indicators are Considered Important?

As mentioned at the onset of this article, lagging indicators are useful in confirming long-term trends – but not for predicting them.  They help investors, managers and consumers understand that the economy has already begun to follow a particular pattern or trend.

In my two prior articles, I reviewed that leading indicators are useful to help predict turning points in the economy and coincident indicators help us compare where we are versus where we’ve been.  Adding on, lagging indicators provide you the ability to understand the strength and reliability of the other two which should reduce uncertainty.

In constructing the lagging economic indicators index, the Conference Board assigns weightings and averages to the individual components listed above in order to smooth out any volatility in the readings.  These are the most recent weightings:

  • Three of the seven components account for almost 70% of the index.  The Average Prime Rate () is the most influential accounting for 28.2% of the index.  Then, Consumer Credit to Income ratio contributes 21.2% and Services CPI  contributes 19.5% to round out the top tier.
  • The remaining measures comprise the balance:  Inventory to Sales 12.1%; C&I Loans 9.7%; Labor Cost per Output Unit 5.9%; and Average Duration of Unemployment 3.6%.

It is interesting to see that short-term lending activity and inflationary forces are considered the most influential.  And, lagging components and unemployment has less of a footprint on it.  After comparing the component types, can you really agree with the general assumption that employment data is one of the most lagging economic indicators?  I know I can’t…

About the Author

Henry V. Kaelber, CPA, CFP®, CGMA