Statistics Binder - Leading Economic Indicators

Leading Economic Indicators are useful for helping to predict turning points in the economy.  Although they are not always as useful as they promise.  However, business managers, consumers and investors can use them to keep their fingers on the pulse of the economy.

Almost every week there is some economic announcement.  These announcements influence business managers and investors outlook on the direction of the economy.  And the media is quick to disseminate this news immediately upon release.  They often line up various experts to deliver timely analysis and tell us what it means.  More often than not, however, the media is either critical of the data or the consensus forecast that preceded it.  And less often, we get a more objective picture of what the data means for the economy as a whole.

How many times have you come away confused by how economic reports are disseminated in the media?  When we hear well articulated opinions representing opposing views, confusion is a very probable outcome for most.  Especially when those views may contain an incorrect assumption or two.

For example, you may have constantly heard that employment data is among the most lagging of economic indicators.  Is this an accurate statement?  Can we really be sure that what we’ve heard is completely true?  If we hear something said enough and the assumption goes unchallenged, it must be true – right?  Not always…

Helping you Understand the Economy

At Henry V. Kaelber, CPA, CFP®, CGMA, 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 will begin a series to discuss to some of the more widely followed economic indicators.  And, I’ll seek to bring context to their usefulness as: leading economic indicators, coincident economic indicators and lagging economic indicators.

Henry V. Kaelber, CPA, CFP®, CGMA is a CPA firm in Charlottesville, Virginia, 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.

The Three Groups of Economic Indicators

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.  Quite often, statistical sampling methods derive data which carry a margin of error.  Usually, the smaller the sample, the greater the potential for sampling error.  Yet despite the potential for error, these “economic indicators” can help guide our ability to make more confident business decisions.  That is, if you take the time to understand what the information is telling you.

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

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.  They compile the data and publish the indices of leading, coincident and lagging economic indicators each month.

The Leading Indicator Index Components

Ten economic measures compose the Conference Board’s leading indicator index model.  These measures are indicative of future economic trends.

Six Related to Business Activity

Average weekly hours, manufacturing.  The US Department of Labor (DOL) releases this statistic.  It represents the average weekly hours worked by employees in the manufacturing sector.  If this average is increasing, it is likley that manufacturers will hire more in the future.

Average weekly initial claims of unemployment insurance.  Released by DOL, it is a measure of new claims for unemployment insurance from “laid-off” workers.  It is debatable that this measure should be a leading indicator.  Yet, it does emphasize the impact of directional changes in employment to the health of the economy.

Manufacturers’ new orders for consumer goods and materials.  Released by the US Census Bureau (CB), this is an inflation-adjusted measure of new orders for consumer products.  Often, the level of new orders by retailers signal whether manufacturers are likely to increase or decrease production activity.

Index of Supplier Deliveries – Vendor Performance.  This data comes from the monthly ISM (Institute for Supply Management) Survey.  This is a measure of purchasing manager responses as to whether deliveries from suppliers have been faster, slower or the same as the previous month.  Slower deliveries are associated with increased demand for supplies.  Increased demand for supplies is a positive for the economy.

Manufacturers’ new orders for non-defense related capital goods.  This is an inflation-adjusted measure of new orders for assets used in the production of goods and services.  It measures business spending.   The CB also releases this statistic.  This is the counterpart to the consumer new orders measure.  Think of this as an indicator of the demand for “larger ticket” items.

Building permits for new private housing units.  An increase in building permits is a good indicator for increased construction activity.  In turn, new construction activity often drives other types of economic activity.  The CB also releases this statistic.

Plus Four More Related to Money Activity

Stock prices for the S&P500:  the S&P500 represents a broad selection of large company common stocks.  This widely followed stock index reflects the general sentiment of investors.  It also produces a wealth effect that can reinforce confidence or caution.

Interest rate spread between 10yr US Treasury Bonds and the Fed Funds rate.  The spread is the difference between the interest rate for 10yr UST bonds less the overnight borrowing rate between banks (the Fed Funds rate).  When the spread is positive general financial conditions are supportive of an expanding economy.  A positive spread is when the 10yr UST bond rate is higher than the Fed Funds rate.  And when it becomes negative, its record for indicating that we are heading for a recession is very strong.

Index of consumer expectations.  This data is the result of the University of Michigan’s consumer sentiment survey.  This monthly survey samples approximately 500 households, asking roughly 50 questions to determine their expectations on three broad areas:  1) their family’s financial prospects over the next year; 2) how they view prospects for the general economy over the next year; and, 3) how they view the general economy over the next 5 years.

Money supply.  This measure used is an inflation-adjusted version of M2.  M2 is a money supply measure.   The Federal Reserve Bank releases this measure.  M2 includes currency in circulation, traveler’s checks, checking and savings deposits, small denomination time deposits (such as CD’s less than $100,000) and balances in money market accounts.

Why is The Money Supply Important?

An increase in money supply, above the rate of inflation, creates a favorable environment for businesses to expand.   The actions of the Federal Reserve Bank support his outcome.  In order to produce a stimulating effect for the economy, the Federal Reserve will undertake to flood the economy with money.

However, an increase in M2 may not always be a positive signal.  If M2 is increasing because investors are abandoning risky investments and consumers are beginning to hoard cash, these reasons would signal a very negative trend for the economy.   As such, the money supply measure should always be considered relative to other indicators in the economy at any given point in time.

Which Indicators are Important?

Leading indicators are useful for helping predict turning points in the economy.  Although they are not always as useful as they promise.  However, investors, business managers and consumers can use them to keep their fingers on the pulse of the economy for various reasons.

Investors are perhaps the most ardent followers of economic indicators as they dictate how their investments will perform.  For example, stock market investors like to use leading indicators to determine the health of economic growth and if the trend looks positive for higher corporate profits.  While bond investors, on the other hand, prefer less rapid growth as they are more sensitive to how their markets would react if inflationary pressures surfaced.

To a lesser degree, business managers use this data to help them determine whether to expand or contract inventories, make or hold back on equipment purchases, and to help them make employment decisions.  And, to a much lesser degree, consumers can use this information to help making both work and spending decisions.

Individual Components Weightings

In constructing the leading indicator index, the Conference Board assigns weightings and averages to the individual components listed above in order to smooth out any volatility in the readings.  The weightings given to the individual components are summarized as:

  • Two of the ten components account for 61% of the index.  Both M2 (35.5%) and Average Weekly Hours (25.5%) are considered the most influential in the current measure.
  • Three more components account for an additional 24.6% of the index (85.6% for the 5 components taken together).  The Interest Rate Spread (10.2%), New Orders for Consumer Goods (7.7%) and Supplier Deliveries (6.7%) are considered moderately influential in the index.
  • And, the remaining indicators account for 14.4% of the index.

Are The Weightings Reasonable?

Upon review, one could debate the emphasis given by the Conference Board in the Leading Economic Indicators index composition.  This is because any number of changing factors can drive the dynamics of the economy.  And, it often takes an educated guess as to which indicator is the more influential at the moment.  In fact, the Conference Board has made major revisions to the index.  The last one occurred in mid-2005.  Then, they reduced the significance of the Interest Rate Spread from 33% of the LEI index to 10.2%.

However, one shouldn’t get caught up in debating the LEI index composition weightings.  Most might agree that the individual indicators maintain good logic without regard to how they are weighted.  In fact, many investors evaluate the separate component data released long before the index is reported later in the month.

Perhaps, the more interesting aspect of the LEI index is emphasis given Average Weekly Hours worked in the manufacturing sector.  It certainly helps dispel the generality that employment data represents the most lagging of economic indicators.  Some aspects of employment data may be lagging, yet it may not serve us well to dismiss all.

About the Author

Henry V. Kaelber, CPA, CFP®, CGMA