A leading indicator is an economic crystal ball that gives your insight into a possible future change in the direction of an economy or business. Often presented in a mathematical framework, a leading indicator is a measurable economic variable, which foretells a potential economic change and helps policymakers predict a future market or business situation.
Leading indicators should be considered as pointers and not accurate predictors. They help you make a near-accurate market guess but those guesses may or may not turn out as expected.
Leading indicators also help to predict the timing, extent, and magnitude of future economic and business conditions. In this article, we attempt to explain the importance of leading indicators.
We also analyze key indicators that businesses and investors should consider before they make a business or investment decision.
What Makes a Leading Indicator Important?
Leading indicators are essential to predict the future trend of an economy, a business, or a market. They show how a market performance will occur in the future.
Unlike a lagging indicator which is an economic rear mirror that shows how things have been, the leading indicator acts as the dashboard. It gives an idea of the present obtainable occurrences and insight into future development.
Leading indicators give a mathematical perspective to future events and helps you predict and plan objectively.
Five Leading Economic Indicators
Economic indicators help you measure the level of economic recovery (or otherwise) even before the economy tilts in response. The popular economic indicators include the yield curve, durable goods orders, the stock market, building permits, and manufacturing orders.
A yield curve is a graph that compares the interest of bonds or treasury bill’s across several maturity dates. Yield curves have proven beneficial in predicting a recession.
As an investor, the yield curve helps you ascertain your proposed returns after a certain period. Another advantage of the yield curve is that it indicates the rise or fall of interest rates.
A decrease in interest rates will make people and businesses more prone to take loans. This in turn increases consumption and advances the economy. When interest rates are high, however, the reverse occurs and the economy slows down.
Durable Goods Orders
This is another economic leading indicator that is essential especially in production. Durable goods order provides insight on manufacturing activities.
When consumers’ orders increase, production increases. In like manner, a decrease in orders will amount to an eventual decrease in production.
Durable goods orders are used by investors as an economic indicator to predict changes in the manufacturing industry. They give leads on the supply chain of production.
They also give insight into the returns in associated industries such as transportation and machinery.
Investors purchase stocks not based on past performance but predicted future performance. The stock price is not always in synchrony with the economic performance.
An economy might be crawling while its stock market booms. Often the stock prices increase when investors predict future economic growth irrespective of the present situation.
The price of the stock market can serve as an economic indicator to ascertain the potential growth of an economy.
This is term can be classified as the manufacture of one or more products. It contains general information such as proposed start and finish dates, quantity and units ordered reference to the demand source, etc. Investors can ascertain the direction of a product on the manufacturing flow based on its status on the order.
One could determine a country’s future economic trajectory by the building permit reports. A nation’s currency value could appreciate if the building permit report is stronger than predicted.
Although not many investors pay attention to building permits, they serve as a strong economic indicator in forecasting the economic conditions in a nation.
How Do I Calculate These Indicators?
Several indexes can be useful when calculating leading indicators. Some of them include the Purchasing Managers Index (PMI), The Consumer Confidence Index (CCI), the Composite Index of Leading Indicators (LEI), amongst others.
The Purchasing Managers Index (PM) helps investors understand what purchasing managers think about the future of their businesses. The index analyzes the individuals who purchase raw materials required by manufacturing companies to make a product.
To calculate this, a survey is given amongst purchasing managers to find out their opinion about the growth of their industry or business. The survey is implied out across new orders, supplier delivery, employment figures, etc.
The general response from the purchasing managers is then collated to give a monthly score. A figure of less than 50 shows a decline in the manufacturing sector economy and vice versa.
Consumer Confidence Index (CCI) is another indicator that one can measure to ascertain economic growth. The survey consists of a 5-question questionnaire administered every six months and used to ascertain consumer’s perceptions of present economic conditions and future expectations.
The CCI is considered the barometer of the US economy because it gauges the spending desires of the consumers. If consumers perceive that their present spending capacities are reduced due to business and unemployment rates, it will curtail their spending and reduce sales.
Leading Indicators for Businesses
While leading indicators predict economic activities, they also forecast the onset of business cycles. These indicators include average work hours in manufacturing per week, factory orders for goods, housing permits, index of customer expectation, interest rate spread, and stock prices.
These leading indicators tend to shift in the precision of a business cycle.
Leading Indicators for Investors
As an investor, some leading indicators to consider before investing include the stock market, manufacturing activities, stochastic oscillator, yield curve, relative strength index (RSI), building permits. Because leading indicators have a reputation with economic forecasts, governments and policymakers employ them when making plans and projects.
Accuracy & Assumptions of Leading Indicators
It is essential to know that leading indicators are not facts. Just as the name suggests, they give pointers or forecasts to a future economic or business trend.
A typical instance is the inverted yield curve which accurately predicted all the recessions before the 1970s. However, in the mid-1960s, an inverted yield curve was seen but no recession followed.
Investors and business personnel should learn to hinge on the forecasts that leading indicators give. They should also put into consideration other factors that could affect the prediction.
Get More Help
Leading indicators have proven beneficial to governmental agencies, policymakers, private investors, and business leaders. A focus on lagging indicators such as profits is not a wise venture when it comes to investment decisions.
Therefore, leading indicators have a better chance of helping you make informed economic decisions. You would need to study several leading indicators to have a comprehensive and holistic analysis of your investment options.
This is where you require a financial advisor. A financial advisor will help you understand the market trends based on the mathematical data provided by leading indicators. This will assist and aid your understanding and inform your investments or business decisions.