Leading Indicators – Easy Pod (May 9, 2014)
Leading indicators are in the business of predicting the future, so they’re definitely worth discussing. I’m continuing a feature I’m calling “Easy Pod” – a collection of indicators that help portray the current status of something. In this post, that something is leading indicators, which are indicators that help us determine where the economy will be a few months from now. Let’s first review quickly what leading indicators are and why they matter. (If you’ve read this Easy Pod before, skip down to below the first horizontal line.)
NOTE: You may be reading an outdated article. You may be interested in reading my latest Leading Indicators Easy Pod.
Quick ‘n Easy
Leading indicators are indicators that tend to predict what will happen several months down the road. The “leading” refers to the fact that the indicators will often change in a particular direction before the actual economic situation catches up.
From Wikipedia (I know, I know, but they had the best definition!):
Leading indicators are indicators that usually change before the economy as a whole changes. They are therefore useful as short-term predictors of the economy.
Sure it’s great to know what the GDP for last quarter was or how much consumers spent last month. But those all give us a sense for what’s happening right now. When I want to make decisions (like how to invest my money, whether to put off a purchase, etc.) I need to know about the future. That’s why we are interested in leading indicators, a set of magic numbers that tell us exactly where the economy will be in about 6 months, with 100% certainty. OK, so that’s not entirely true. Actually, it’s totally a lie. But the point is that these indicators are much more correlated (that’s a fancy term for things that happen together) with the future state of the economy than other indicators are.
There are a number of indicators that do this, and there are even some people who combine these indicators into one number (an index) to give a summary. In this “Easy Pod” I will take a look at a few of those indices that I like to follow. Check back regularly for updates.
Previous Easy Pod: July 19, 2013
Indicator: Leading Economic Index | POSITIVE
Easy Intro: None yet | Leading Economic Index – The Conference Board – Click here | Latest Date This Info Represents: March 2014
Quick ‘n Easy
An index that combines the results of ten leading indicators into one number suggests that the pace of economic growth through September 2014 will be positive, at or above the historical average rate. The report shows that 7 of the 10 components were positive contributors for the latest month, which saw the index rise 0.8 percent versus the previous month.
Easy Description: Basically, this index from The Conference Board is a combination of several indicators that traditionally correlate well to the future state of the economy, generally 6-9 months ahead. For simplicity, we won’t talk about all the indicators that it combines. You can read about it yourself by clicking on the source link above.
From The Conference Board’s website:
The composite economic indexes are the key elements in an analytic system designed to signal peaks and troughs in the business cycle.
We’re singling out the “leading” part of their index. They have other indices that tell us how things are now (coincident) and how they have been (lagging).
When this index declines in value by about 1-2% over several months, and during that time most of the individual components of the index are declining, that is a pretty good sign that a recession is coming soon.
Latest Reading: The latest reading of the Leading Economic Index is 100.9, which is 0.8 percent higher than the previous month. The index is now 2.7 percent higher over the last six months, which translates to an annualized rate of about 5.6 percent. During that time, 7 of the 10 components have improved. In the latest month, 7 out of 10 components that make up this index were better than the previous month (although not necessarily a “positive” contributor for the month). For the latest month, the biggest source of positive contribution in any single component came from the difference between 10-year Treasury yield and the federal funds rate (“interest rate spread”) – but this is artificially affected by the Federal Reserve’s lowering of interest rates, and so it may be overly optimistic. The previous month’s most positive component was the same. The worst component for the latest month is building permits, which are an indication of upcoming construction of new houses. This has been a bit up and down over the last six months.
Implications: I like to look at components that go from very good to very bad or vice versa versus three months prior, which I’ll assign a threshold value of +0.10 and -0.10 for simplicity.
Versus three months ago:
- Changed from very bad to very good (-0.10 or worse to +0.10 or better)
- Changed from very good to very bad (+0.10 or better to -0.10 or worse)
Once again, one of the single largest contributors (1st place this month) is the “Interest Rate Spread.” Unfortunately, this has to do with the Federal Reserve’s interventions (reducing interest rates). Normally, better interest rate spreads are true leading indicators, but not so much when their presence is largely “artificial” to some degree. This has consistently remained a positive contributing component. The economists from The Conference Board indicated that the index is suggesting the accelerated growth in the U.S. economy through the spring and summer.
Easynomics Rating Methodology: For this index, I will calculate the change in the LEI over the recent six months. I will convert that change into an annualized rate. If the annualized rate is less than zero, I will issue a “negative” rating – 3.3 percent or higher will be “positive” – anything in between will be “neutral.”