Leading economic indicators are statistics that precede economic events. They predict the next phase of the business cycle. That becomes especially critical when the economy is either coming out of a recession or heading into one.
Leading, Lagging, and Coincident Indicators
The other two types of indicators are coincident and lagging indicators.
Coincident indicators occur during the trend. The number of employees added or subtracted each month is the most influential coincident indicator. The Employment Situation Summary is released by the Bureau of Labor Statistics.
There are three types of economic indicators: leading, coincident, and lagging.
Lagging indicators occur after the trend. They either confirm or refute the trend predicted by leading indicators. For example, the unemployment rate typically rises after a recession has ended. There's a good reason for that. Even when growth improves, employers are hesitant to hire full-time workers again. They wait to see if they can count on the growth continuing.
Top Five Leading Indicators
There are five leading indicators that are the most useful to follow. They are the yield curve, durable goods orders, the stock market, manufacturing orders, and building permits.
The Yield Curve
The Treasury yield curve is the most important indicator for the average person. It predicted all of the last eight recessions: 1970, 1973, 1980, 1990, 2001, and 2008. The yield curve also inverted before the 2020 recession.
The yield curve shows the return on short-term Treasury bills compared to long-term Treasury notes and bonds. In a normal yield curve, returns on short-term notes will be lower than the longer-term bonds. Investors need a higher yield to invest their money for longer.
When the yield curve inverts, it often foreshadows a recession, but the timing of the ensuing pullback is highly unpredictable. Incidentally, an inversion occurs when short-term Treasury bills and notes offer a higher yield than longer-dated Treasury bonds. If investors are willing to accept a lower return for the long-term bonds, then you know they are very uncertain about the near future.
The yield curve also tells you whether interest rates are rising or falling. Low interest rates make loans cheaper. It allows businesses to expand, and families to buy cars, homes, and education. When interest rates rise, you know the economy will slow down soon. It costs more to take out a loan, making everyone buy less.
The yield curve is not perfect. It inverted in 1966, although no recession occurred afterward.
Durable Goods Orders
The durable goods orders report tells you when companies order new big-ticket items. Examples are machinery, automobiles, and commercial jets. This isn't the same as consumer purchases of durable goods, such as washing machines and new cars. That's important, but business orders change before the business cycle changes.
For example, when the economy weakens, companies delay purchases of expensive new equipment. They'll just keep the old machines running to save money.
The first thing firms do when they regain confidence in the future is to buy new equipment. They need to replace the old machinery and gear up for higher anticipated demand.
Orders for durable goods declined in January 2008. A few months later, the Bureau of Economic Analysis declared the 2008 recession. Durable goods orders began falling in October 2018, months before the 2020 recession.
The stock market is a good predictive indicator. A company's stock price represents the firm's expected earnings.
Investors spend all day, every day, researching the health of businesses and the economy. A rise in stock prices means they are more confident about future growth. A fall in the stock market means investors are rushing toward traditional safe-havens. They'll sell stocks and buy 10-year Treasury notes or gold.
The Dow Jones Industrial Average crashed on March 9, 2020, accurately forecasting the 2020 recession.
However, both the stock market decline and the ensuing recession were directly related to anxiety, uncertainty, and economic disruption associated with the COVID-19 outbreak.
Pay particular attention to the Dow Jones Utility Average. It measures the stock performance of 15 big utilities. These companies borrow a lot to pay for energy generation facilities. As a result, their profits depend on interest rates. When rates are low, their earnings are up, and so is the utility index.
The number of manufacturing jobs tells you manufacturers' confidence level. Although overall employment is a coincident indicator, factory jobs are an important leading indicator.
Compare how many manufacturing jobs were added this month with the Bureau of Labor Statistics' Jobs Report.
When factory orders rise, companies need more workers. That benefits other industries like transportation, retail, and administration. When manufacturers stop hiring, it means a recession is on its way.
Building permits tell you what will happen with new home construction nine months from now. Most cities issue the permit two to three months after the buyer signs the new home sale contract. That's six to nine months before builders complete the new home.
The U.S. Census publishes the number of building permits issued each month. Download the excel spreadsheet title "Permits by State - Monthly." Make sure to use the tab marked "Units SA" for the seasonally adjusted rate.
When permits start to fall, it's a clue that the demand for new housing is also down. When that happens, it usually also means something is wrong with the resale market. Real estate is a significant component of the economy, as are construction jobs. When this sector weakens, everyone feels it.
For example, economists made that mistake in the 2008 recession. They thought the subprime mortgage crisis would be contained within real estate. As early as October 2006, building permits for new homes were down 28% from October 2005. It was an early indicator of the housing crisis and the 2008 global financial crisis.
Index of Leading Economic Indicators
The U.S. Conference Board publishes a Leading Index that is, itself, a good indicator of what's going to happen in the economy. If you can only look at one indicator, this would give you a quick snapshot. Since it is a composite, it won't give as full a picture as the five indicators outlined above.
The Index measures 10 leading economic indicators. Five of them are listed above. These are combined with the five indicators summarized below. These indicators aren't as useful as the top five at predicting economic trends. The reasons are outlined below:
- Weekly Claims for Unemployment - Investors use this report to predict the monthly jobs reports. But it measures the unemployment rate. That's usually a lagging indicator. Employers avoid laying off workers unless they absolutely have to. They also don't rehire until they are absolutely sure the economy is getting better. The unemployment rate often rises long after the recession is over.
- ISM Index of New Orders - This surveys more than 400 purchasing executives in the manufacturing sector. If the new orders report is above 50, manufacturing and the economy are growing. It is a very useful indicator, but if you are short on time, the Durable Goods Orders Report will reveal a similar outlook.
- Leading Credit Spread - It measures six financial indicators, such as margin account balances, bank credit, and security repurchases. It is a good forward indicator if you understand the underlying financial products and their potential impact on the credit industry. The Treasury yield curve has similar predictive capacity.
- Consumer Expectations - This is based on a survey of consumers. It asks for their future expectations. It tells you whether consumers think business conditions, jobs, and incomes will improve in six months. Most respondents base their future predictions on how well they are doing now. For example, many people are still unemployed even after a recession is over.
How to Use Leading Indicators
Leading indicators are the first data point in a new phase of the business cycle. They occur during the old cycle but give a preview of what's about to happen. Here's how to use each of the top five indicators.
Yield Curve: Keep an eye on the yield curve monthly. It can invert years before a recession actually occurs. For that reason, monitor it but don't take action until other leading indicators confirm the yield curve's trend.
Durable Goods Orders: Review the durable goods order report monthly. It will vary significantly month to month. A large portion of it is commercial aircraft, mostly Boeing, and its orders swing wildly. Also, look at the portion of the report called "Capital Orders Without Defense and Transportation." It eliminates the unevenness of commercial and defense aircraft orders.
Stock Market: The stock market also has a lot of daily variabilities. Most of it is noise, but it's important to note if the market falls more than 20%. That's a bear market, and it usually accompanies a recession.
Manufacturing Jobs: Manufacturing jobs are released monthly in the Jobs Report. If it steadily declines month after month, you know a recession is likely.
Building Permits: The building permits report is also released monthly. A quick review will tell you how developers feel about the future of housing.