What is a Leading Indicator?
How Does a Leading Indicator Work?
Popular leading indicators include average weekly hours worked in manufacturing, new orders for capital goods by manufacturers, and applications for unemployment insurance. Lagging indicators include things like employment rates and consumer confidence.
The business cycle has highs and lows. That's why predicting what's around the corner is one of the best (and most difficult) ways to protect and grow portfolios. Leading indicators, which are typically indices composed of a set of securities that tend to be very sensitive to economic fluctuations and thus move sharply higher during the early stages of expansion or lose value quickly when economic conditions deteriorate, can provide that crucial information.
Leading indicators are often indexes, but they can also be certain stocks. For example, let's assume XYZ Company is an auto manufacturer. If XYZ Company stock typically falls before the rest of the automotive sector falls or rises before the rest of the automotive sector rises, we could consider XYZ Company a leading indicator in the auto industry.
Why Does a Leading Indicator Matter?
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.