Nervous investors have been waiting for confirmation that the economy truly is recovering. Unfortunately, by the time they get that reassurance, it'll already be too late to grab the best bargains from the stock market.
It's only natural to want to see brighter signs of an economic recovery before you put your money at risk investing in stocks. However, economists have discovered that during most business cycles, certain things come early during a recovery -- or even before one. Meanwhile, many of the things that people want most only happen well after the recovery has taken hold.
Understanding lagging indicators
It's that second category that most people are most nervous about. For instance, high unemployment hits close to home, since so many of us have little or no emergency savings to turn to if we lose our jobs. With the unemployment rate pushing 10%, many see the job-loss figures that persist month after month as a sign that those who insist that a recovery is coming are delusional.
Similarly, others point to signs that when it comes to spending, consumers are failing to hold up their end of the bargain. Especially with the all-important holiday shopping season nearly upon us, weakness in consumer spending could be catastrophic to retailers from Amazon.com (Nasdaq: AMZN) to Target (NYSE: TGT). Yet many argue that banks like Citigroup (NYSE: C), Bank of America (NYSE: BAC), and Wells Fargo (NYSE: WFC) are stymieing demand by making it more difficult for consumers to get credit.
Average duration of unemployment and consumer credit, however, are examples of lagging indicators. Typically, the length of time people are unemployed and the amount of credit they have access to don't predict a coming economic recovery. Instead, these things only get worse after a recession starts -- and they stick around until long after it's technically over.
If you think about it, that makes common sense. A struggling business won't hire until it's sure it's out of the woods financially. Similarly, banks don't want to lend to consumers until they're sure that borrowers will be able to afford to pay them back.
Focus on leading indicators
If you want to look for predictors of a strong economy, you should instead look to leading indicators. Two of those indicators are related to employment: the average work week for manufacturing workers and the number of initial claims for unemployment insurance. But you have to look closely to find some of that information, as most people focus more on headline numbers like how many jobs are created or lost.
Yet again, when you think about it, it makes sense that average work week is a leading indicator. Before hiring someone new, manufacturing companies like Ford Motor (NYSE: F) and United Technologies (NYSE: UTX) will strive to get as much productivity out of their current workforce as possible, especially during a recession. Only once it becomes clear that demand is outpacing a company's ability to produce new goods will employers feel most comfortable hiring again.
Other important leading indicators include orders for consumer goods, money supply, stock prices, and interest rates. Lately, most of those indicators have been pointing up, which has pushed the Conference Board's index of leading indicators up in each of the past six months at a staggering annualized rate of 11.8%.
Don't wait
All this underscores the fact that in order to invest successfully during an economic downturn, you have to go against your natural inclination to protect your money when times are bad. Because the stock market is a leading indicator while employment and consumer credit are lagging indicators, stocks will usually rise well before there's any sign that the lagging indicators have hit bottom -- which is exactly the situation we’ve seen since March.
So the next time you think a stock market rally is completely unfounded, just keep in mind that it may be predicting better times ahead. If you wait for those better times to become obvious, then it'll be too late to grab the bargains that less skeptical investors get before a recovery even begins.
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