Understanding the Economy: Leading Indicators

Posted by   admin on    December 15, 2010

Understanding the Economy: Leading Indicators

Almost every week there is some economic announcement that influences investors outlook on the direction of the economy. And the media is quick to disseminate this news immediately upon release - often lining up various experts to deliver timely analysis and tell us what it means. More often than not, however, the dialogue aired is either critical of the data or of the consensus forecast that preceded it. And less often, we get a more objective picture of what the data means for the economy as a whole.

How many times have you come away confused by how economic reports are disseminated in the media? When we hear well articulated opinions representing opposing views, confusion is a very probable outcome for most listeners - especially when those views may contain an incorrect assumption or two.

For example, you may have constantly heard that employment data is among the most lagging of economic indicators. Is this an accurate statement? Can we really be sure that what we've heard is completely true? If we hear something said enough and the assumption goes unchallenged, it must be true - right? Not always.

Each month, various governmental agencies and research associations compile and release a wide variety of information about the economy. Much of this data is after the fact information or relates to measures of confidence. In addition, quite often the data is derived from statistical sampling methods which carry a margin of error - usually, the smaller the sample, the greater the potential for sampling error. Yet despite the potential for error, these economic indicators can help guide our ability to make more confident business decisions. That is, if you take the time to understand what the information is telling you.

This article will begin a series to discuss to some of the more widely followed economic indicators. And, Ill seek to bring context to their usefulness through summarizing them as: leading indicators, coincident indicators and lagging indicators.

As these categories indicate, leading indicators help to predict what the economy will do in the future; coincident indicators help us understand the current state of the economy; and lagging indicators help to confirm or deny the validity of the other two.

For the sake of efficiency and debate, I will describe these indicators in groupings used by The Conference Board. The Conference Board is a global, independent and research association who compiles data and publishes the indices of leading, coincident and lagging indicators each month.

The Leading Indicator Index Components

The Conference Boards leading indicator index model is composed of ten economic measures that are currently thought to be indicative of future economic trends. Each component indicator is described as follows:

  • Average weekly hours, manufacturing: this is the average weekly hours worked by employees in the manufacturing sector released by the US Department of Labor (DOL). It is believed that if this average is increasing, manufacturers will begin hiring (more) at some point in the future.
  • Average weekly initial claims of unemployment insurance: this is a measure of new claims for unemployment insurance from laid-off workers also released by DOL. While it could certainly be debated whether this should be a leading indicator, it does emphasize the impact of directional changes in employment to the health of the economy.
  • Manufacturers new orders for consumer goods and materials: this is an inflation-adjusted measure of new orders for consumer products released by the US Census Bureau (CB). Often, the level of new orders by retailers will signal whether manufacturers are likely to increase or decrease production activity.
  • Index of Supplier Deliveries - Vendor Performance: this data comes from the monthly ISM (Institute for Supply Management) Survey. This is a measure of purchasing manager responses as to whether deliveries from suppliers have been faster, slower or the same as the previous month. Slower deliveries are often associated with increased demand for supplies  which would be considered a positive for the economy.
  • Manufacturers new orders for non-defense related capital goods: this is an inflation-adjusted measure of new orders for assets used in the production of goods and services  business spending  also released by the CB. This is the counterpart to the consumer new orders measure. Think of this as an indicator of the demand for larger ticket items.
  • Building permits for new private housing units: an increase in building permits is a good indicator for increased construction activity. In turn, new construction activity often drives other types of economic activity. This is another statistic released by the CB.
  • Stock prices for the S&P500: the S&P500 represents a broad selection of large company common stocks. This widely followed stock index not only reflects the general sentiment of investors, it also produces a wealth effect that can reinforce confidence or caution.
  • Money supply: this measure used is an inflation-adjusted version of M2. M2 is a money supply measure released by the Federal Reserve Bank that includes currency in circulation, travelers checks, checking and savings deposits, small denomination time deposits (such as CDs less than $100,000) and balances in money market accounts.

It is thought that an increase in money supply, above the rate of inflation, creates a favorable environment for businesses to expand. Such is the premise being followed by the Fed through its undertaking to flood the economy with money (the infamous QE2 experiment) in hopes that it will produce a stimulating effect for the economy. However, an increase in M2 may not always be considered a positive signal. If M2 is increasing because investors are abandoning risky investments and consumers are beginning to hoard cash, these reasons would signal a very negative trend for the economy. As such, this money supply measure should always be considered relative to other indicators in the economy at any given point in time.

Interest rate spread between 10-yr. US Treasury Bonds and the Fed Funds rate: the spread is the difference between the interest rate for 10-yr. UST bonds less the overnight borrowing rate between banks (the Fed Funds rate). When the spread is positive (10-yr. UST bond rate is higher than the Fed Funds rate) general financial conditions are supportive of an expanding economy; and when it becomes negative, its record for indicating that we are heading for a recession is very strong.

Index of consumer expectations: the data looked at here is the result of the University of Michigan's consumer sentiment survey. This monthly survey samples approximately 500 households, asking roughly 50 questions to determine their expectations on three broad areas: 1) their family's financial prospects over the next year; 2) how they view prospects for the general economy over the next year; and, 3) how they view the general economy over the next 5 years.

Which Indicators are Considered Important?

Leading indicators are thought to be useful for helping predict turning points in the economy although they are not always as useful as they promise. However, investors, business managers and consumers can use them to keep their fingers on the pulse of the economy for various reasons.

Investors are perhaps the most ardent followers of economic indicators as they dictate how their investments will perform. For example, stock market investors like to use leading indicators to determine the health of economic growth and if the trend looks positive for higher corporate profits. While bond investors, on the other hand, prefer less rapid growth as they are more sensitive to how their markets would react if inflationary pressures surfaced.

To a lesser degree, business managers use this data to help them determine whether to expand or contract inventories, make or hold back on equipment purchases, and to help them make employment decisions. And, to a much lesser degree, consumers can use this information to help making both work and spending decisions.

In constructing the leading indicator index, the Conference Board assigns weightings and averages to the individual components listed above in order to smooth out any volatility in the readings. The weightings given to the individual components are summarized as:

  • Two of the ten components account for 61% of the index. Both M2 (35.5%) and Average Weekly Hours (25.5%) are considered the most influential in the current measure.
  • Three more components account for an additional 24.6% of the index (85.6% for the 5 components taken together). The Interest Rate Spread (10.2%), New Orders for Consumer Goods (7.7%) and Supplier Deliveries (6.7%) are considered moderately influential in the index.
  • And, the remaining indicators account for 14.4% of the index.

Upon review, one could debate the emphasis given by the Conference Board in the LEI index composition. I say this because I am someone who believes that the dynamics of the economy can be driven by any number of changing factors and find that it is always takes an educated guess as to which indicator is the more influential at the moment. In fact, the Conference Board has made major revisions to the index  the last one occurring in mid-2005. Then, they reduced the significance of the Interest Rate Spread from 33% of the LEI index to 10.2%.

However, one shouldn't get caught up in debating the LEI index composition weightings. Most might agree that the individual indicators maintain good logic without regard to how they are weighted. In fact, many investors are evaluating the individual component data released long before the index is reported later in the month.

Perhaps, the more interesting aspect of the LEI index is emphasis given Average Weekly Hours worked in the manufacturing sector. It certainly helps dispel the generality that employment data represents the most lagging of economic indicators. Some aspects of employment data may be lagging, yet it may not serve us well to dismiss all.

ELF's Outlook and Performance

Novembers market performance was much like a roller coaster. By the first weeks end, stocks hit their highest level in 26 months; and, by the end of the second week, the markets suffer their worst week in three months  settling below the months starting point. If the markets performance resembled that of a roller coaster, the first half of the month was the breath-taker. In the second half of November, the train went through two more rises and falls  settling on level ground (flat for the month). Now, as this letter is coming out mid-December, we've just climbed another significant rise. Yet, this ride may offer something that is quite different.

In the last six weeks, there have been some significant news events for investors to consider: It all started with learning that Republicans seized control of Congress in the midterm elections; and with the Federal Reserve saying it will pump $600 billion into the economy (think M2 growing). This, then got dampened by a negative outlook from Cisco Systems and fears of an economic slowdown in China. Then, we learned that General Motors became a publicly traded company again with a positive first day of trading. Then, North Korea attacked one of South Koreas islands  which was nothing short of an act of war. At the same time, we were revisiting another European debt crisis focusing on Irelands woes. As these concerns seemed to rapidly abate the market began to rally after learning of positive economic news (indicators) for the U.S. highlighted by much better than expected November retail sales figures. Then, if the positives didn't seem to offset the negatives enough, President Obama seemed to move more towards the center by inking a positive trade agreement with South Korea and began a push to work with Republicans to seek an extension of the Bush tax cuts along with some other stimulative measures. Over such a short period of time, this was a lot to absorb.

In developing our own thoughts, this months letter not only serves to provide you food for thought, it serves up some of our own cooking for our top-down analysis and outlook. In reviewing the more influential leading indicators: M2 has been growing significantly throughout the 4th quarter and the Fed recently confirmed its commitment to pump more into the economy; Average Weekly Hours have been slowly increasing and are already above an average 40 hour work week; the Interest Rate Spread has been widening positively; New Orders for Consumer Goods has been growing slowly; and Supplier Deliveries have been slowing at a relatively fast pace. None of these signals are mixed and all are positive for future economic growth.

During November and into December we have continued to nibble on putting money to work into an updated buying list. Our process involves looking for reasonably priced growth opportunities. Our current view is to become 95% invested over the near term.

Our portfolio clients ended the month of November down 1.59%. Here are some comparative numbers for you to review:

ELF-strategy-chart-nov10.gif

For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

ELF is an independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities. ELF may also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for both individual and business clients.

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF. Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less. There is no minimum account size for inclusion into ELFs ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

ELF's performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELF's ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any. ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.

Broad market index information provided is solely for the purpose of comparison. This index data was obtained from third party sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should not be construed as an investment in an index or in a program that seeks to replicate any index. In most cases, investors choose a market index having comparable characteristics to their portfolio as a benchmark. An ETF is a security that tracks an index benchmark or components thereof. As ELF actively manages a strategic allocation of primarily ETFs, selecting a comparable benchmark poses significant challenges. Over time, the broad market indices provided above may exhibit more, similar or less variability of returns and risk than ELFs strategic allocation. As well, the broad market index information provided above reflects gross returns and have not been reduced by any estimated fees or expenses that a person might incur in trying to replicate an index.

Copyright 2010 ELF Capital Management, LLC. All rights reserved.