Leading Indicators

Leading Indicators

Among leading indicators, the leading economic index (LEI) for the United States was implemented in 1996 and introduced the interest rate spread as a measure for recessions but also measures used to cover manufacturing orders, commodity, prices, and inflation. The LEI index is thought to change in advance of the general economy; thus, it is used to gauge whether the pace of future business activity is expected to accelerate, decelerate, or trend sideways.

The LEI can be approximated using the free series provided by the FRED database (series indicated in parenthesis). The leading indicators can be assigned a weight to facilitate the overall interpretation of each component. My free implementation includes:

  • Average length of the manufacturing workweek in hours (AWHMAN)
  • Average length of the construction workweek in hours (CES2000000007)
  • Total Employment in manufacturing (MANEMP)
  • Total Employment in manufacturing (USCONS)
  • Current New Orders; Diffusion Index for New York (NOCDISA066MSFRBNY)
  • Current New Orders; Diffusion Index for New York (NOFDISA066MSFRBNY)
  • Consumer Sentiment University of Michigan (UMCSENT)
  • 10-Year Treasury Constant Maturity Minus Federal Funds Rate (T10YFF)
  • Value of Manufacturers’ New Orders for Consumer Goods: Durable Goods Excluding Defense Industries (ADXDNO)
  • Chicago Fed National Financial Conditions Credit Subindex (NFCICREDIT)
  • New Private Housing Units Authorized by Building Permits (PERMIT)
  • A stock index representative of the economy. For instance, the S&P 500 index. However, indexes based on capitalization are generally biased.
Leading indicators

Lenght of working week in hours

Whenever manufacturers or constructors require workers more hours, it is expected an increase in orders and in economic activity with additional hiring. The opposite can occur prior to recessions. Depending on the forecast objectives, manufacturing or construction can be employed with a weight of 28%. Total employment should be read together in order to mitigate too many positive signals conveyed by the workweek indicator.

New Orders – Diffusion Index

The index decreases prior to the start of recessions and increases before recessions end. An Index and advanced statistics are ready-made from the Institute of Supply Management providing a more general index. Weight: 18%.

Consumer Sentiment

Consumers are supposed to spend more during mid and late expansions due to optimism. Moreover, consumer spending accounts for about 70 percent of U.S. GDP. Drops should be carefully monitored. Weight: 16%.

Interest Rate Spread

The difference between the interest rate on a 10-year Treasury note and the shorter-term Federal Funds rate is a proxy for the slope of the Treasury yield curve. A decrease in the spread points to an upward slope anticipating a recovery in the economy, whereas an increase points to a flattening slope anticipating a slowing economy. Note that because Fed Funds rate are kept close to zero the resulting yield curve is not technically inverted. Weight: 10%.

Value of Manufacturers’ New Orders for Consumer Goods

Consumers are supposed to commit to bigger purchases during mid and late expansions due to confidence in the economy. New orders typically signal an expansion. Weight: 10%.

Chicago Fed National Financial Conditions Credit

The diffusion index is anchored to zero (it signals distances from the neutral point). Negative or decreasing values suggests borrowing conditions are getting easier, whereas increasing or positive values suggests borrowing conditions are getting tighter. Weight: 10%.

New Private Housing Units Authorized by Building Permits

An increase in the number of permits for new private housing signals optimism on the part of homebuilders and prospective buyers. A decrease in the number of permits signals pessimism. However, permits are often and often linked to public policy. Weight: 8%.

Other Indicators

Level of New Business Startups. The number of new businesses entering the economy is another indicator of economic health. In fact, some have claimed that small businesses hire more employees than larger corporations and, thereby, contribute more to addressing unemployment. Moreover, small businesses can contribute significantly to GDP, and they introduce innovative ideas and products that stimulate growth. Therefore, increases in small businesses are an extremely important indicator of the economic well-being of any capitalist nation.

Business Confidence. The business confidence index (BCI) is based on enterprises’ assessment of production, orders, and stocks, as well as its current position and expectations for the immediate future. Opinions compared to a “normal” state are collected and the difference between positive and negative answers provides a qualitative index on economic conditions. The Institute for Supply Management produces the most followed index, called the Purchasing Manager Index. It is published monthly on the first business day of the following month.

Housing Market. A decline in housing prices can suggest that supply exceeds demand, that existing prices are unaffordable, and/or that housing prices are inflated and need to correct as a result of a housing bubble. In any scenario, declines in housing have a negative impact on the economy because they decrease homeowner wealth, they reduce the number of construction jobs needed to build new homes, increasing unemployment, they reduce property taxes, which limits government resources. Homeowners are less able to refinance or sell their homes, which may force them into foreclosure. When you look at housing data, look at two things: changes in housing values and changes in sales. When sales decline, it generally indicates that values will also drop.

References

Weigand (2012). Applied Equity Analysis and Portfolio Management

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