The recent bounce in the stock market -- more than 20% from its March lows -- has everyone looking for more signs of a stabilizing economy. To predict exactly when the economy may start recovering, however, you have to look beyond rising stock prices.
Economists have searched for reliable predictors of economic recoveries for a long time. That's the idea behind the index of leading economic indicators, or LEI index, developed by the nonprofit Conference Board to help people navigate the ups and downs of business cycles.
But the LEI index isn't just useful for knowing in advance when an economic recovery may start. It can also give you a better sense of which sectors are likely to respond first when economic activity picks up.
Breaking down the index
The LEI index measures 10 different factors that it believes typically lead the economy upward and downward over time. They break down into three main categories:
- Financial measures, including interest rate spreads between short- and long-term rates, money supply, and stock market performance.
- Production-related gauges, such as building permits, supplier deliveries, average manufacturing hours, and new orders by manufacturers for consumer goods and capital goods.
- Consumer-related measures, including weekly unemployment claims and consumer expectations.
The Conference Board gives each factor a certain weight in calculating the overall index.
As you'd expect, the LEI index has fallen substantially recently -- 3.7% over the past year and 2.1% in just the past six months. Yet in the most recent data release, a majority of the factors turned positive for the first time since last April. Given the stock market's strong performance in March, the LEI index may well turn positive when March's figures are reported later this month.
Stocks to buy before the recovery
Trying to get a jump on when the LEI index will indicate a coming recovery -- a signal that may well turn into a self-fulfilling prophecy, if most consumers continue to base their spending decisions on the latest news -- may prove difficult. Trying to time the economy is no easier than timing the stock market.
However, unless you believe that things truly are different this time, and that the current recession will just keep getting worse, the LEI index provides some hints regarding which industries may be the first to turn back up when the recovery inevitably comes. In particular:
- With interest rate spreads currently adding the strongest positive push to the LEI index, banks definitely have a strong tailwind pushing them forward. The largest banks, like Citigroup
(NYSE:C)and Bank of America (NYSE:BAC), have a long way to go before recovering. But smaller regional banks such as Hudson City Bancorp (NASDAQ:HCBK), which haven't suffered nearly as much, should reap the benefits of favorable spreads a lot more quickly.
- The LEI index looks closely at manufacturing activity, in part because of its huge impact on the rest of the economy. Big industrials such as Boeing
(NYSE:BA)and U.S. Steel (NYSE:X)have both laid off workers recently, but a general economic rebound could give them respite from the huge pullbacks of the past year.
- In contrast, the defensive stocks to which so many investors have retreated -- resilient companies such as McDonald's
(NYSE:MCD)and Wal-Mart (NYSE:WMT)-- could easily see interest dry up as people start seeing more positive results in other areas. Although increased consumer demand could help defensive stocks, it would likely help other companies even more -- companies that sell luxury items that consumers have put off buying during the recession.
Of course, you can't be sure whether you're too early in acting to profit from a recovery. If you're wrong, and the economy suffers another leg down, you may see some fairly substantial losses if you buy today.
But for long-term investors, the prospects for huge profits are probably too good to pass up. And given how far many of these stocks have fallen already, the downside risk is fairly small compared to the potential rewards. Invest with the recovery in mind, and sooner or later, the economy will prove you right.
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