The index of leading indicators is one of a number of cyclical indicators and is considered a barometer of recession or recovery.
There are three indexes — leading, coincident and lagging indicators — which are designed to track turning points in the economy. They use what is generally referred to as the cyclical-indicators approach in identifying peaks and troughs. Specific time series are studied to see whether they historically tend to lead, coincide or lag broad movements of the business cycle. These historic relationships are then used to identify the turning points in a current business cycle.
Each index measures different parts of the economy at the same time. The series that tend to lead at the business cycle turns are combined into one index, those that tend to coincide into another and those that tend lag into the third.
The indexes are considered to be superior to individual series because they represent a broad spectrum of the economy and because in different business cycles some individual indicators may do better than others. In particular, the components that perform best in each cycle may vary, and it would be hard to tell which would be better for each turning point.
Using a composite index reduces some of the risk of tracking the economy with the wrong component or wrong few components. Also, it reduces some of the monthly measurement error associated with a given cyclical indicator.
The composite index of leading indicators is the most closely followed of the three indexes because it typically foreshadows changes in the direction of the economy. Policy-makers, players in the financial markets and business persons can help forecast the economy’s direction.
The components of the Composite Index of Leading Indicators are:
• Average weekly hours of production or non-supervisory workers
• Average weekly initial claims for unemployment insurance
• Manufacturers’ new orders
• Contracts and orders for plant and equipment
• Index of new private housing units authorized by local building permits
• Index of stock prices
• Vendor performance
• Change in sensitive materials prices
• Change in manufacturers’ unfilled orders
• Index of consumer expectations
Many analysts use the common guide that a turn in the economy must be preceded by three consecutive declines in the index of leading indicators before a recession, of the three consecutive increases prior to a recovery. There are rules for two or four straight months, but the three-month rule is the most commonly used. A word of warning: Since World Ward II, the index has signaled 10 recessions, but only seven have occurred.
Quote of the week: “It is costly wisdom that is bought by experience” — Roger Ascham
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.