Ahhh, the dismal science – economics. So called because of the dismal (and spectacularly wrong) projections of mass starvation made by 19th century economist Thomas Malthus. Calling economics dismal may be appropriate, calling it a science is sometimes questionable. Economist have been wrong so many times, you may wonder why we bother to look when they publish their findings!
Lucky for us, economist and government record keeping have improved enough to make at least some of the data and applications of economic theories relevant to an investor’s decision making processes. One set of data – Leading Economic Indicators (LEI) – can be particularly interesting and useful for active investors.
What If You Knew the Winners – In Advance?
Investing in equities – ownership in businesses (commonly referred to as owning stocks) – is a bet on the growth of the human economy. That makes us inherently optimists. Our results are linked with economic growth of a nation, a region, a sector and the world at-large. LEI helps document and predict where economic growth is headed.
Even if you don’t have a million dollar portfolio (but particularly if you’d like one), learning to interpret and respond to the LEI data can help protect and grow your portfolio.
Not just your stock portfolio but all types of assets:
- real estate,
- precious metals, and
- small businesses
react to economic cycles.
When we have the opportunity to get in early (buy low), our profits can easily be double or triple what later investors receive. So, perhaps you’d like to invest a few minutes studying the dismal science of economics – particularly what LEI is and how to use what you learn to improve your investment returns?
Ten Little Numbers…
The Composite Index of Leading Indicators published by an independent group, The Conference Board, is the most widely accepted definition of LEI. Their index includes 10 components in the United State’s economy:
- “BCI-01 Average weekly hours, manufacturing
- The average hours worked per week by production workers in manufacturing industries tend to lead the business cycle because employers usually adjust work hours before increasing or decreasing their workforce.
- BCI-05 Average weekly initial claims for unemployment insurance
- The number of new claims filed for unemployment insurance are typically more sensitive than either total employment or unemployment to overall business conditions, and this series tends to lead the business cycle. It is inverted when included in the leading index; the signs of the month-to-month changes are reversed, because initial claims increase when employment conditions worsen (i.e., layoffs rise and new hirings fall).
- BCI-08 Manufacturers’ new orders, consumer goods and materials (in 1982 $)
- These goods are primarily used by consumers. The inflation-adjusted value of new orders leads actual production because new orders directly affect the level of both unfilled orders and inventories that firms monitor when making production decisions. The Conference Board deflates the current dollar orders data using price indexes constructed from various sources at the industry level and a chain-weighted aggregate price index formula.
- BCI-130 ISM new order index
- This index reflects the levels of new orders from customers. As a diffusion index, its value reflects the number of participants reporting increased orders during the previous month compared to the number reporting decreased orders, and this series tends to lead the business cycle. When the index has a reading of greater than 50 it is an indication that orders have increased during the past month. This index, therefore, tends to lead the business cycle. ISM new orders is based on a monthly survey conducted by Institution for Supply Management (formerly known as national Association of Purchasing Management). The Conference Board takes normalized value of this index as a measure of its contribution to LEI.
- BCI-33 Manufacturers’ new orders, non-defense capital goods excl. aircraft (in 1982 $)
- This index, combining with orders from aircraft (in inflation-adjusted dollars) are the producers’ counterpart to BCI-08.
- BCI-29 Building permits, new private housing units
- The number of residential building permits issued is an indicator of construction activity, which typically leads most other types of economic production.
- BCI-19 Stock prices, 500 common stocks
- The Standard & Poor’s 500 stock index reflects the price movements of a broad selection of common stocks traded on the New York Stock Exchange. Increases (decreases) of the stock index can reflect both the general sentiments of investors and the movements of interest rates, which is usually another good indicator for future economic activity.
- BCI-107 Leading Credit Index™
- This index is consisted of six financial indicators: 2-years Swap Spread (real time), LIBOR 3 month less 3 month Treasury-Bill yield spread (real time), Debit balances at margin account at broker dealer (monthly), AAII Investors Sentiment Bullish (%) less Bearish (%) (weekly), Senior Loan Officers C&I loan survey – Bank tightening Credit to Large and Medium Firms (quarterly), and Security Repurchases (quarterly) from the Total Finance-Liabilities section of Federal Reserve’s flow of fund report. Because of these financial indicators’ forward looking content, LCI leads economic activities.
- BCI-129 Interest rate spread, 10-year Treasury bonds less federal funds
- The spread or difference between long and short rates is often called the yield curve. This series is constructed using the 10-year Treasury bond rate and the federal funds rate, an overnight interbank borrowing rate. It is felt to be an indicator of the stance of monetary policy and general financial conditions because it rises (falls) when short rates are relatively low (high). When it becomes negative (i.e., short rates are higher than long rates and the yield curve inverts) its record as an indicator of recessions is particularly strong.
- BCI-125 Avg. Consumer Expectations for Business and Economic Conditions
- This index reflects changes in consumer attitudes concerning future economic conditions and, therefore, is the only indicator in the leading index that is completely expectations-based. It is an equally weighted average of consumer expectations of business and economic conditions using two questions, Consumer Expectations for Economic Conditions 12-months ahead from Surveys of Consumers conducted by Reuters/University of Michigan, and Consumer Expectations for Business Conditions 6-months ahead from Consumer Confidence Survey by The Conference Board. Responses to the questions concerning various business and economic conditions are classified as positive, negative, or unchanged.”
If the manufacturing output slows, that could predict a slowdown in the sale of goods (retail) and the payrolls of non-manufacturing workers. We may anticipate growth in consumer staples like food and energy at the expense of luxury or discretionary goods and services like travel.
If M2 growth accelerates, and new building permits jump, the real estate sector – home builders particularly – may be a good addition to our portfolio.
And Five More for Going International
When looking to invest outside the United States, we start by looking at five common economic indicators:
- Industrial production
- A measure of the total economic output of the industrial sector of an economy, including manufacturing, mining and utilities. These sectors of total GDP are highly sensitive to interest rates and consumer demand.
- Construction Output
- The total value of construction work within a country. Construction is correlated to a bullish (growing) economic outlook. International investors may want to use the measure as a leading indicator for the overall economy of a particular country or region.
- Business Confidence
- A survey of executives of private companies within a country to gauge their sentiment. These reports attempt to project into the future by assessing the thoughts, feelings and plans of the decision-makers in private enterprises.
- Changes in Inventories
- The smallest component of GDP but an important indicator for investors to watch since large changes signal changes in aggregate demand, which can predict future economic activity fairly accurately.
- New Orders
- The value of contracts between producers and consumers for future delivery. Often broken down by industry, which can provide insight into the economic health of specific economic sectors.
You may be aware of other economic indicators because there are three general types:
- Leading indicators: predict the future of the economy (our LEI)
- Lagging indicators: historical data of what has happened in the past in the economy
- Coincident indicators: describe what’s happening in the economy now (or when data is collected)
All are important in describing the total economic picture and trying to predict future economic activity but the LEI or leading indicators are most useful to us as equity investors.
I’ll cover some of the others in another lesson – become familiar and learn to use the LEIs for now and you’ll improve your odds of becoming a successful investor.
Live Long and Prosper – Leah, the MoneyDiva.com