There is a vast array of economic data available to help investors make informed investment decisions. Some figures, like international trade numbers in the U.S. current account, focus solely on what has already happened. Other numbers, like the Producer Price Index and data on new-home construction, present information about past events that have recognizable causal connections to future outcomes.
The Conference Board, a non-profit organization whose mission includes collecting information to help improve business performance, tracks various types of economic data. It then takes this data and tries to draw conclusions about the current and future economic environment for businesses. The end result is the Board's set of business cycle indicators, the best-known of which is the index of leading economic indicators, or LEI index. This article examines the methodology behind the Board's calculations to help you understand the conclusions they draw about the state of the economy.
The basic concept
The main premise behind the Conference Board's methodology is that the overall economy moves in a repeating pattern that includes periods of faster growth followed by periods of slower growth (or economic contraction). This pattern, known as the business cycle, does not have any fixed, predictable length; the time between low points has ranged from as short as a couple of years to as long as nearly a decade. Following a period of contraction -- also known as a recession -- economic growth eventually begins to accelerate and a recovery period begins. As growth becomes stronger, a period of relative prosperity ensues. Eventually, however, growth slows and often stops, at which point a recession occurs. The next recovery period begins the next cycle.
The purpose of the Conference Board's business cycle indicators is to help businesses understand where the economy is in the cycle. It does this by looking at many types of economic data and then dividing the data into three categories: leading indicators, coincident indicators, and lagging indicators. Certain types of data, such as money supply and number of hours worked by manufacturing workers, tend to anticipate changes in the direction of the overall economy; these types are used as leading indicators. Other types of data, including non-farm payroll numbers and personal income, tend to change at about the same time as the overall economy; these are coincident indicators. The lagging indicators tend to change after the overall economy moves and are used to confirm the trend; the current prime lending rate and levels of inventory relative to sales are examples of lagging indicators. The Conference Board then builds three different indices, taking each of the indicators it uses and applying a weighting factor that reflects the level of variation in each indicator. For instance, overall stock prices are used as a leading indicator, but they have a much smaller impact on the index than the spread between the yield on 10-year Treasury notes and the current federal funds rate.
Because the hardest thing for investors to do is to predict the future, the index of leading economic indicators tends to get the most attention. There are ten types of data the Conference Board uses to calculate the LEI index. In order of weighting, they are: money supply (M2), average hours for manufacturing workers, the 10-year/fed funds rate spread, consumer goods orders, vendor performance in delivering orders, stock prices, weekly unemployment claims, consumer expectations, building permits, and capital goods orders. In general, if the LEI index is rising, then the economy's growth is expected to accelerate; if the LEI index falls, then growth will slow.
Economic implications
Many economists use rules of thumb to define certain events. For instance, many feel that a recession occurs when the change in GDP is negative in two consecutive quarters. Similarly, with the LEI index, economists look for three consecutive months of movements in the same direction to confirm a change in the direction of the economy. Currently, the economy is coming out of a peak in the business cycle, and economists are looking for clues as to when a recession may next occur. This morning's report showed the LEI index dropping 0.2% in August, representing the fifth time in the last seven months that the index has fallen. This is likely to confirm popular suspicions about the slowing economy.
Guidance on coming economic trends is invaluable for businesses making major strategic decisions. For instance, if a major manufacturer like Toyota
When dealing with predictive data, it's always important to check whether or not the predictor does a good job of predicting what actually happens. A common criticism of the LEI index is that it is overly sensitive and therefore predicts more recessions and recoveries than actually occur. However, it's more appropriate to direct this criticism at the interpretation of the index. To use the LEI index properly, you should look not only at the month-to-month change reported in the headline number, but also at comparisons over longer terms. For instance, over the past six months, the LEI index has dropped by 0.6%, a relatively small drop. In addition, while the overall index has dropped, the same number of its component sets of data have risen as have fallen. The Conference Board's press release suggests that the economic trend supported by the data is more flat than declining. Yet you could easily miss this if you only saw the headline number or an interpretation that failed to delve more deeply into the data.
In summary, the Conference Board's index of leading economic indicators is a helpful tool used by economists to track current and future movements in the overall economy. By looking at the LEI index, you can make appropriate investment decisions and predict how prevailing economic trends are likely to affect you.
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Uncertain times call for strong investment choices that can weather financial storms. Shannon Zimmerman constantly searches for these investments in the Motley Fool's Champion Funds newsletter. If you'd like to take a look at our list of recommended funds, model portfolios, back issues, and members-only discussion boards, take advantage of our free 30-day trial.
Fool contributor Dan Caplinger firmly believes that when the leading indicators point up, he's gotta wear shades. He doesn't hold positions in any of the companies mentioned in this article. The Fool's disclosure policy will never leave you in the dark.
