A leading indicator is an economic trend that market experts and economists use to try to predict the future direction of the economy. The Federal Reserve, in particular, relies heavily on leading economic indicators to help it set the direction of interest rates. And if it's important enough for the Fed to use, it's probably important enough for you to use, too.
A business association called The Conference Board has combined a number of indicators into one, easy-to-reference number called The Conference Board Leading Economic Index, or LEI. The index is a handy snapshot of the economy's health and is referenced throughout the financial world, but you should familiarize yourself with all of its components in order to get a better idea of where the economy is growing -- and where it is shrinking.
The most important leading economic indicators include: Gross Domestic Product (GDP); the Consumer Price Index; the Producer Price Index; Employment Indicators; the Retail Sales Index; surveys performed by the National Association of Purchasing Managers (NAPM); Consumer Confidence; the Fed's 'Beige Book' of regional economic conditions; Durable Goods Orders; the Employment Cost Index (ECI); and a gauge of corporate productivity.
Tracking these underlying components, instead of the LEI index itself, will really help you get an edge in today's market. Here's a brief description of the most important leading economic indicators.
Gross Domestic Product (GDP)
This is a quarterly snapshot of the U.S. economy, and perhaps the most recognized economic indicator. The reading, which is released on the last weekday of every quarter, measures how the rate of economic growth fared in the prior quarter, when compared to a year earlier. Generally speaking, GDP growth in excess of 3% is required to help stimulate job growth and provide a positive backdrop for stocks.
Consumer Price Index (CPI)
The CPI measures the change in prices for a wide range of goods that consumers typically purchase. This basket of goods is weighted to reflect the relative importance of each input, though many prefer to gauge price changes for all goods except food and energy.
These two factors can be very erratic from month-to-month, and may give a distorted view of what is actually taking place in the economy. At times of sharply rising consumer prices, the Federal Reserve tends to raise interest rates to blunt the economic pressures that may be fueling price hikes. Yet the Fed is also wary of falling prices, known as deflation, as it could be a harbinger that the economy is shrinking. Moreover, deflation may make it harder for loans to be paid while asset values fall below loan amounts, as we've seen in the housing crisis. The CPI had been a very important measure in the 1970s and 1980s when inflation was higher, but this economic indicator has been very tame in recent years, downgrading its importance to economists.
Producer Price Index (PPI)
The PPI measures price changes in the production and wholesale sectors of the economy, reflecting the cost environment for many businesses. As is the case with the CPI, many economists strip out the cost of food and energy to get a read on “core” inflation. As is also the case with the CPI, the PPI has been very tame in recent years, and is not currently of great concern to economists. If and when unemployment falls towards the 7% mark and GDP growth has been sustained for an extended period, economists will likely track the CPI and the PPI more closely.
Depending on which LEI methodology is applied, the monthly employment report and/or weekly jobless claims are important factors. The monthly report, which is released on the first Friday of every month, reflects the month-to-month change in non-farm payrolls and is seen as a clear harbinger of future economic activity. The amount of jobs created does not necessarily correlate with the unemployment rate. In an improving economy, discouraged workers may again seek employment, joining the ranks of those formally counted as being unemployed. That explains why some economists dislike the unemployment rate; While it currently stands in the 9% to 10% range, if the ranks of discouraged workers that aren't even looking for work are counted, the actual unemployment rate is closer to 17%.
The weekly jobless claims -- released every Thursday morning -- are especially volatile, which is why many tend to look at the four week moving-average of jobless claims for a more accurate figure. A figure below 350,000 is generally associated with net job creation.
Retail Sales Index
The Retail Sales Index, typically released in the middle of the month, measures the rate of sequential sales growth of retail goods, though the number is massaged to account for seasonal variations. Auto sales, a key component of the Retail Sales Index, tend to be quite volatile, so many economists strip it out when assessing retail sales trends. Retail sales are a crucial part of a growing economy, as they impact a wide range of industries in terms of employment. Rising retail sales and a climbing Retail Sales Index are solid predictors of future economic growth.
To get a strong feel for conditions in the industrial sector, the Institute for Supply Management (ISM) conducts a monthly survey with purchasing managers to gauge the level of activity and pricing trends. The survey broadly seeks to determine whether business is growing or shrinking in our nation's factories. A reading above 50 implies that the industrial sector is expanding, while a reading below 50 implies that this segment of the economy is contracting. Any reading above 60 can start to raise concerns that inflationary pressures will soon build in the economy. The Federal Reserve keeps close watch and will raise interest rates if necessary in order to blunt inflationary momentum in the industrial sector.
Consumer Confidence Surveys
There are several monthly consumer confidence surveys conducted by organizations such as the University of Michigan and the Conference Board. These surveys looks to assess how consumers are currently feeling about their employment picture and general optimism, along with their view of where they expect these conditions to be six months from now. Some surveys also look at the volume of jobs listed in classified ads as a sign of real conditions on the ground. Although used in various leading economic indicator analyses, consumer confidence surveys are considered a lagging indicator and are not especially useful in predicting future levels of economic activity.
The Beige Book
Every eight weeks, economists who work for the Federal Reserve's open Market Committee (FOMC) compile a broad data set of economic conditions from every part of the country. These economists also speak with a selection of professional contacts, bankers, and economists to get a qualitative read on economic conditions. The resulting Beige Book summary is an important tool for the FOMC to make any changes in interest rates. In recent quarters, the Beige Book has consistently yielded results that indicate a still-weak economy, and as a result, has not captured a great deal of attention. While the economy heats up, the Beige Book will be closely watched by market strategists to see if the FOMC will shift course with respect to interest rates.
Durable Goods Orders
Companies and consumers alike tend to spend only what is necessary in tough times, only to step up their spending beyond necessities once they grow more confident in the economy. That's why the measurement of spending on durable goods -- any item that is expected to last more than three years -- is a clear read of consumer and corporate confidence. As an example, a cautious consumer is likely to hang on to their aging car, but a more confident consumer is more likely to consider purchasing a new car. The same logic applies to major home renovations or industrial capital equipment.
Yet economists are quick to strip out the impact of spending on airplanes, which is a big factor in durable goods production -- notably volatile. The monthly durable goods report, issued by the Commerce Department, is seen as a strong complement to the ISM's NAPM surveys noted above. Taken together, these economic reports provide a clear snapshot of industrial activity.
Employment Cost Index and Corporate Productivity
Employment Cost Index and Corporate Productivity are often analyzed in conjunction, allowing economists to gauge whether employment compensation is rising and whether employees are being productive in the context of any rise in employment costs. Generally speaking, an increased in productivity measures (which analyze the level of output divided by the number of workers) can blunt the impact of any rising payroll costs. If employee productivity and compensation both rise by 3%,then the next cost to employers is negligible and the inflationary impact of wage hikes is of less concern.
How Investors Can Use Economic Indicators to Their Advantage
It is definitely worthwhile for investors to track leading economic indicators because they reveal which aspects of the economy are showing relative strength. For example, if multiple variables such as payrolls, exports, and the purchasing managers survey are all rising, investors can expect economic growth to remain steady or even rise in coming quarters -- which is always a good thing for stocks. That's a trend that individual traders can support.
Leading economic indicators can also send you clues regarding inflationary or deflationary pressures. If the economy is starting to fire on all cylinders, investors may grow concerned that inflationary bottleneck pressures will emerge, forcing the Federal Reserve to push up interest rates. Rising rates can become a headwind for the stock market if they rise too high. (i.e., Prime Rate above 5%). Conversely, a fast-dropping set of leading economic indicators could signal interest rate cuts in the future.
The LEI -- and its various sub-components -- have not been as heavily utilized in the last few years with the economy in a funk. Signs are now emerging that the economy is starting shed its cocoon, and these various measures will give us a clear read on how -- and at what pace -- the economy is developing. You should familiarize yourself with the economic indicators discussed above, and make it a habit of assessing the data when they are released. This knowledge will help you stay one step ahead of the early adopters when it comes to spotting future turns in the stock market.