What Is a Leading Indicator?
Leading indicators are measurable indexes that signal potential upcoming changes in trends, business conditions, and the economy. Policymakers and other economic experts use these forecasts and predictions to make wiser financial decisions.
How Does a Leading Indicator Work?
Leading indicators are typically composed of a set of securities that are sensitive to economic fluctuations. Therefore, they tend to move sharply higher during the early stages of expansion – or lose value quickly when economic conditions deteriorate.
Example of Leading Indicators
Popular leading indicators include average weekly hours worked in manufacturing, new orders for capital goods by manufacturers, mortgage defaults, and applications for unemployment insurance.
Certain stocks can also be leading indicators. For example, let's assume XYZ Company is an auto manufacturer. If its stock typically falls before the rest of the automotive sector falls or rises before the rest of the automotive sector rises, we can consider XYZ Company a leading indicator in the auto industry.
Leading vs. Lagging Indicators
Leading indicators look towards the future and show policymakers the direction they should head in. Because they are constantly shifting, these are typically more difficult to measure.
A lagging indicator, however, measures the current performance and tends to be easier to measure than leading indicators. These can include elements like employment rates and consumer confidence. Because lagging indicators are
Why Are Leading Indicators Important?
Since the business cycle regularly experiences highs and lows, predicting upcoming trends is one of the best (yet most difficult) ways to protect and grow portfolios.
Show Relative Strength
It’s worthwhile for investors to track leading economic indicators because they can reveal which aspects of the economy are showing relative strength.
If multiple variables (e.g. payroll and exports) are all rising, investors can expect economic growth to remain steady or even rise in coming financial quarters. This is always a good thing for stocks – and a trend that individual traders can support.
Leading economic indicators can also provide clues regarding inflationary or deflationary pressures. If the economy is beginning to fire on all cylinders, investors may grow concerned about inflationary bottleneck pressures that could force 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.