Leading Economic Indicators and How to Use Them
Are We Headed Into Another Recession? Check These Indicators First
Leading economic indicators are statistics that precede economic events. They predict the next phase of the business cycle. That becomes critical when the economy is either coming out of a recession or heading into one.
Top Five Leading Indicators
Interest rates are the most important indicator for the average person to follow. Falling and low interest rates create liquidity for businesses and consumers. That means money is cheap, and both are more likely to buy as soon as the economy improves. 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 Durable Goods Orders Report tells you when businesses order new big-ticket items. Examples are machinery, automobiles, and commercial jets. Why is this important? 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 they do when they regain confidence about the future is to buy new equipment. This isn't the same as consumer purchases of durable goods, such as washing machines and new cars. That's important, but business orders pick up first when a downturn ends.
The stock market is a good predictive indicator. Investors spend all day, every day, researching the health of businesses and the economy. A rise in stock prices means they are more confident of 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 and gold.
Pay particular attention to the Dow Jones Utility Average. It measures the stock performance of utilities. These companies have to borrow a lot to finance their expensive energy generation facilities. As a result, their earnings are dependent upon interest rates. When rates are down, their earnings are up, and so is the utility index.
The number of manufacturing jobs tell you manufacturers' confidence level. Although headline employment is a coincident indicator, factory jobs are an important leading indicator. 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 give you a nine-month lead in new home construction. 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. When permits start to fall, it's a clue that 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 percent from October 2005. It was an early sign of the housing crisis and the 2008 global financial crisis.
Although not one of the top five, the Federal Reserve's Beige Book is a useful leading indicator. It provides powerful insights into how the economy is doing at a grassroots level. Each of the 12 local Federal Reserve banks collect information from local sources. They talk to their branch directors, business leaders, economists, and local experts. The report discusses how each region's businesses are affected by national and global trends.
Index of Leading Economic Indicators
The U.S. Conference Board publishes an index that measures the top five indicators. It combines this with other leading indicators. These indicators aren't as useful as the top five at predicting economic trends. The reasons are outlined below. The Index includes:
- Money Supply - This doesn't take into account money invested in stock or bond funds. They also affect liquidity. The Fed's interest rate moves immediately impact the money supply.
- 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.
- Weekly Claims for Unemployment - Investors use this report to predict the monthly jobs reports. But it measures the unemployment rate. It's a lagging indicator. It doesn't predict what the economy will do next.
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. For example, orders for durable goods occur six months before the company needs it. When the order ships, it shows up in economic output.
Coincident indicators occur during the trend. For example, gross domestic product reports how much the economy produced in the last quarter. It also compares last quarter to the previous quarter. That gives you GDP growth.
Lagging indicators occur after the trend. They either confirm or refute the trend predicted by leading indicators. The unemployment rate tells you the economy has already begun to shift. Even when growth slows, employers are hesitant to let trained workers go. They hope conditions will improve. When they finally lay them off, the recession is already underway. But the durable goods order report told you that long ago.