Lagging Indicators

Lagging Indicators

Lagging indicators represent financial signs that becomes apparent only after a large economic shift has taken place. Such indicators are used to confirm the recent strength or weakness of economic activity. The Conference Board Lagging Index generally reacts after the start of recessions and expansions.

Using the free series provided by the FRED database (series indicated in parenthesis), it is possible to replicate some of the most used lagging indicators of the Conference Board. The lagging indicators can be assigned a weight to facilitate the overall interpretation of each component. My free implementation includes:

  • Bank Prime Loan Rate (MPRIME)
  • Total Consumer Credit Owned and Securitized, Outstanding (TOTALSL) to Personal Income (PI)
  • Consumer Price Index for All Urban Consumers: Services (CUSR0000SAS)
  • Total Business: Inventories to Sales Ratio (ISRATIO)
  • Commercial and Industrial Loans, All Commercial Banks (BUSLOANS)
  • Average (Mean) Duration of Unemployment (UEMPMEAN)
Lagging Indicators

Bank Prime Loan Rate

An expansion in the economy is often paired growing demand for credit with banks increasing their spread. When the economy slows, demand for credit weakens, and banks need to reduce their spread and the prime rate falls. However, low rates alone do not imply an expansion as in the case of a weak expansion not followed by credit expansion (i.e., low rates but zero or a negative number of new loans). Additionally, the monetary policy of Central Banks may distort the prime rate by artificially maintaining a zero interest rate policy (ZIRP). In other terms, banks do not, or are unable, to transmit credit to the real economy. Weight: 29%.

Ratio of Total Consumer Credit to Personal Income

It is expected that consumers wait to increase borrowing for at least several months after a recession ends. Thus, the ratio tends to reach a low after personal income has risen for more than a year assuming that consumers attempt to balance income and debt. Weight: 21%.

Services Consumer Price Index

Services inflation, although declining in the long-term, is expected to increase several months after the start of a recession, and decrease several months after the start of an expansion.  Note that the CPI index includes Housing prices with a 40% weight; thus, a transaction based index should be considered when assessing the CPI. In practice, a weighted average of inflation and assets prices can enhance the predictive power of the indicator. For instance, CPI less housing plus asset prices with a weight of 60-70% for inflation and 30-40% for asset prices (including property and other assets). Weight: 19%.

Inventory to Sales Ratio

Globally, the effectiveness of Supply Management practices has determined a downtrend in the ratio. Notwithstanding, the ratio peaks in the middle of a recession, as businesses find it harder to sell existing inventory. Weight: 12%.

Commercial and Industrial Loans

Business loans peak after an expansion (as declining profits increase the need for borrowed funds), whereas lows occur a year or more after a recession ends. Weight: 9%.

Manufacturing Unit Labor Costs

Unit labor costs peak midway through a recession, then decline or trend sideways until several months into the next economic expansion. Note that pressures for higher wages are represented only in the real unit labor costs: however, businesses usually adjust wages to a lower extent than expected inflation. Weight: 6%.

Average Duration of Unemployment

Decreases in the average duration of unemployment tend to occur after an economic recovery gains traction and employers begin hiring in earnest. Weight: 3%.

Other Indicators

Corporate Profits. Strong corporate profits are correlated with a rise in GDP because they reflect an increase in sales and therefore encourage job growth. They also increase stock market performance as investors look for places to invest income. That said, growth in profits does not always reflect a healthy economy. For example, in the recession that began in 2008, companies enjoyed increased profits largely as a result of excessive outsourcing and downsizing (including major job cuts). Since both activities took jobs out of the economy, this indicator falsely suggested a strong economy.

Balance of Trade. The balance of trade is the net difference between the value of exports and imports and shows whether there is a trade surplus (more money coming into the country) or a trade deficit (more money going out of the country). Trade surpluses are generally desirable, but if the trade surplus is too high, a country may not be taking full advantage of the opportunity to purchase other countries’ products. That is, in a global economy, nations specialize in manufacturing specific products while taking advantage of the goods other nations produce at a cheaper, more efficient rate. Trade deficits, however, can lead to significant domestic debt. Over the long term, a trade deficit can result in a devaluation of the local currency as foreign debt increases. This increase in debt will reduce the credibility of the local currency, which will inevitably lower the demand for it and thereby the value. Moreover, significant debt will likely lead to a major financial burden for future generations who will be forced to pay it off.

Value of Commodity Substitutes to U.S. Dollar. Gold and silver are often viewed as substitutes to the U.S. dollar. When the economy suffers or the value of the U.S. dollar declines, these commodities increase in price because more people buy them as a measure of protection. They are viewed to have an inherent value that does not decline. Furthermore, because these metals are priced in U.S. dollars, any deterioration or projected decline in the value of the dollar must logically lead to an increase in the price of the metal. Thus, precious metal prices can act as a reflection of consumer sentiment towards the U.S. dollar and its future. For example, consider the record-high price of gold at $1,900 an ounce in 2011 as the value of the U.S. dollar deteriorated.

The Producer Price index (PPI) is a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. PPIs measure price change from the perspective of the seller and differs from other indexes, such as the CPI, that measure price change from the purchaser’s perspective. The PPI looks at three areas of production: industry-based, commodity-based and commodity-based final demand-intermediate demand. So, if a product has a base PPI of 100 and then in the following month it has a PPI of 110, it’s indicating that the price of that product has increased by 10% in relation to the previous period. Current PPIs have the base year set at 100 in 1982.

Currency Strength. A strong currency increases a country’s purchasing and selling power with other nations. The country with a stronger currency can sell its products overseas at higher foreign prices and import products more cheaply. However, there are advantages to having a weak dollar as well. When the dollar is weak, the United States can draw in more tourists and encourage other countries to buy U.S. goods. In fact, as the dollar drops, the demand for American products increases.

References

Weigand (2012). Applied Equity Analysis and Portfolio Management

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