Accurately forecasting market trends on a regular basis isn’t possible, but doing so with a higher degree of confidence than the outcome of a simple coin flip is. Leading economic indicators are among the tools that economists and investment strategists use to make plausible forecasts. However, it’s important not to confuse these indicators with coincident or lagging indicators, which are often mentioned in the media and which tell us about current economic conditions or events that have already occurred.
The power of leading economic indicators
To derive the maximum benefit from economic indicators, you have to know that they fall into different categories and that it’s important to use the right one in the right context. When we discuss our expectations for our investment portfolio, leading economic indicators are key. We will now explain what a leading economic indicator is and see how to use it effectively.
Understanding leading indicators: an example
Let’s say you want to make major renovations to your home, for example, add an extension. Between the time you come up with the idea and the time the work is completed, many steps will have to be taken and it will take many weeks, if not months. You will have to prepare plans and specifications, buy materials, perhaps get financing, etc. And, of course, before making any major outlays, you will have to get a permit from your municipality.
Now consider the economic ramifications of this project. If you need to buy plywood or beams, that wood will have been harvested by a logging company and transported to a sawmill. The logs were transformed into planks and beams, which were then transported to a big box hardware store, where you can now buy them. In this supply chain, specialized machinery, transport trucks, heavy machinery and handling equipment will have been used. These all need operators, preventive maintenance or repairs. Mechanical parts will have been repaired or changed by specialized labour.
We’ve only touched on what’s behind the lumber needed for the framework of the renovation project. We haven’t even mentioned the supply chain for the nails and screws that will be used. Blasting, mining, extraction, smelting, transportation, all these huge ramifications are part of the “economy.” It goes without saying that each of the companies that is part of a production chain or supply chain engages in the activity in order to make a profit. Also bear in mind that stock markets are fueled by profits: that’s what they need to grow.
What economic indicator would forecast this economic chain? Construction or renovation permits issued country-wide indicate the extent of economic activity that will ensue, the extent of all the potential future profits of the companies involved and, ultimately, the extent of the impact on stock markets. This is an example of a context where a leading economic indicator can provide fairly accurate information on future economic activity.
Other leading economic indicators
The previous example showed how the "building permits" leading economic indicator can be used to anticipate the future economic activity that will result from it. There are several economic indicators that have this ability to extrapolate. Here are three others, publicly available and easy to interpret:
Initial jobless claims – This is a high-frequency indicator that provides information on the employment situation and, incidentally, people’s ability to spend money on goods and services. If you’re worried about losing your job or have just lost it, chances are you’ll be putting off a major renovation project for your home. The repercussions will be felt far downstream in the production and supply chains. An important clarification: initial jobless claims should not be confused with the “unemployment rate” economic indicator, which includes both newly unemployed people and those who have been unemployed for some time.
Average weekly work hours – Using overtime is a flexible solution for companies to meet their production capacity needs without having to hire new people. The opposite is also true: in the event of a slowdown, you simply don’t offer any overtime to your workers. By calculating the total number of hours worked, it’s possible to detect trends. An increase or decrease in working hours suggests an increase or decrease in the demand for goods or services and, consequently, in future economic activity.
ISM Manufacturing New Orders and ISM Services New Orders – The Institute for Supply Management, founded in 1915, is the largest non-profit professional supply management organization in the world. It has more than 50,000 members in over 100 countries who work in a multitude of different industries. Monthly, it publishes new order trend data based on information compiled from its members. Several parallels can be drawn with the building permits example presented in the introduction. However, instead of calculating the number of building permits that will bring a host of other players into the chain, it’s the number of new orders received by manufacturing companies that is counted. These companies are a key link and they have an impact on production chains and supply chains.
Using leading economic indicators
Within a relatively short period of time, the various leading indicators tend to signal upcoming changes in economic conditions and, incidentally, the likely impact these changes will have on investment portfolios. A parallel can be drawn with a vegetable garden: if we plant vegetables in rich soil, with good sun exposure, and if we water the garden regularly, we can reasonably expect an abundant harvest, because we have set up favourable conditions for growth. Favourable conditions for market growth in the near future are measurable and observable thanks to leading economic indicators.
A valuable tool in the hands of experts
Predicting future market behaviour with a reasonable degree of accuracy is possible. It’s not a matter of having a crystal ball or relying on one’s intuition, since the close correlation between economic data and the financial markets is measurable.
When a significant proportion of leading economic indicators point in the same direction, we can understand what the future environment will look like and, consequently, what the financial market backdrop will be. Of course, completely unpredictable shocks like a pandemic or a war can always occur. They will certainly have an impact on the financial markets and could change forecasts that were initially well founded.
The experts involved in investment management on a daily basis are able to leverage these metrics and react to unforeseen events, to the benefit of your medium- and long-term investment strategy.
David Raymond, CMT, CFA
Markets and Investment Specialist
