THE BUSINESS CYCLE: THE COMPOSITE INDEX OF LEADING INDICATORS

The composite index of leading indicators is a summary statistic for the U.S. economy. This index is constructed by averaging its individual components in order to smooth out a good part of the volatility of the individual series. The purpose of this index is to provide indication on the future trend of the U.S. economy. As a result, a slower growth in this index foretells that the growth of the economy is likely to decline in the future. On the other hand, an increase in the growth of this index is an indication that the growth of the economy will rise in the near future. The composite index of leading indicators is computed using ten measures that have the property of leading the business cycle at peaks and at troughs. The typical lead-time is about 12 months at peaks and a few months at troughs.

The indicators used to compute the composite Index of Leading Indicators are the following:
1. Average weekly hours in 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 work force.
2. Average weekly initial claims for unemployment insurance. The number of new claims filed for unemployment insurance is typically more sensitive than either total employment or unemployment to overall business conditions. This series tends to lead the business cycle and is inverted when included in the leading index.
3. Manufacturers' new orders, consumer goods and materials. 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.
4. Vendor performance, slower deliveries diffusion index. This index measures the relative speed at which industrial companies receive deliveries from their suppliers. Slowdowns in deliveries increase this series and are most often associated with increases in demand for manufacturing suppliers, and therefore, tend to lead the business cycle. The National Association of Purchasing Managers provides this information which represents the number of managers experiencing slower deliveries. An increase in this index suggests that the economy will improve.
5. Manufacturers' new orders, non-defense capital goods. This series represents new orders received by manufacturers in non-defense capital goods industries. As explained for the series on new orders, new orders for non-defense capital goods lead the business cycle.
6. Building permits, new private housing units. This series represents the number of residential building permits issued. This is an important indicator of construction activity, which typically leads most other types of economic production trends.
7. 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 and decreases in stock prices, which reflect increases and decreases in overall financial liquidity, is another good indicator of future economic activity.
8. Money supply, M2. The money supply M2 is expressed in inflation-adjusted dollars. M2 includes currency, demand deposits, other checkable deposits, travelers’ checks, savings deposits, small denomination timed deposits, and balances in money market mutual funds.
9. Interest rate spread, 10-year Treasury bonds less Federal funds. This series is constructed using the ten-year Treasury bond rate and the Federal Funds rate, an overnight inter-bank borrowing rate. Changes in this spread lead important turning points in economic activity.
10. Index of consumer expectations. This index reflects changes in consumer attitudes concerning future economic conditions and is the only indicator in the leading index that is completely expectations based.

The use of rate of change over 12 months is recommended when using business cycle indicators. The main reason is that asset prices in trends in the financial markets are particularly sensitive to changes in the growth rate of economic indicators. Furthermore, the use of rate of change helps to compare the growth rate of one indicator versus other indicators.

The main reason the index of leading indicators leads turning points of the business cycle is that many of the components used to compute the index reflect decisions or commitments to change output, such as new orders and building permits or measures of financial liquidity, such as money supply and stock prices. Stock prices respond immediately to increases in liquidity injected in the banking system by the Federal Reserve, as discussed in detail later in this book. The term liquidity is representative of how fast the money supply is growing. Rising growth in the money supply means that the Federal Reserve is increasing liquidity in the system, while a decrease in the growth of the money supply implies the Fed is taking liquidity off the banking system. How this is done will be discussed in the chapter concerning the operations of a Central Bank. All these measures affect economic growth with a lead of several months. For instance, the growth of the money supply leads changes in the growth of the economy by about two years.

Orders are a leading indicator, because they reflect the decision of business firms to buy new machines and expand existing capacity. However, it takes time to convert orders into machines or plants. Therefore, such orders tend to precede changes in the production of goods or machinery.

Another important component of the index of leading indicators is building permits. Let's assume that building permits start rising, reflecting a commitment to build more housing due to, for instance, declining interest rates. Rising building permits will eventually be reflected in increased construction activity, in the completion of buildings, in the production of materials that are needed to build houses, and eventually to their final sales.

It is reasonable to expect that some time will elapse from the time the building permit is granted, to the time the production of the equipment needed to build the buildings is completed, and finally for the buildings to be sold. For this reason, changes in the growth of building permits tend to anticipate - that is lead - the growth in overall business activity.

Another important leading indicator is the Index of Stock Prices, as represented by the S&P 500 common stocks index. The stock market is an important leading indicator of economic activity because changes in stock prices tend to lead changes in business activity by several months, and its action is available daily. The reason the stock market is a leading indicator of economic growth is because it reflects, like the money supply, the growth of liquidity in the economic system. For instance, the growth of the money supply and the change in stock prices measured on a year-over-year basis started to increase quite sharply in 1995. Economic growth resumed quite strongly towards the end of 1997 and early 1998.

Since financial liquidity reflects an expansion of credit, the more liquidity is made available, the more money is eventually used in business to build houses, to manufacture goods, to buy other companies, or to invest. A decline in the growth of stock prices signals that liquidity in the economic system is growing more slowly. The outcome is that consumers have less money to spend, investors have less money to invest in new ventures, and overall business activity is likely to slow down.

Another important leading indicator is the growth of the money supply, which measures credit expansion. We will deal in detail with this type of indicator when we talk about the Federal Reserve, which is the central bank of the United States, in Chapter 6. We will also see how the central bank impacts the growth of the money supply, and as a result, the growth of the economy. For the time being, it is enough to say that the money supply is also a measure of liquidity is the economic system and is closely controlled by the Federal Reserve.

When more liquidity is made available through the banks, there is more money to borrow. Consumers and businesses will then borrow and use the money to invest, thus, impacting the growth of the economy. If the liquidity in the banking system slows down, there is less money to borrow, and business activity will slow down because there is less money available to spend and to invest.

The composite index of leading indicators provides an overview of the future trends of the economy. It simplifies the analysis because it summarizes trends of ten indicators that in the past have proven to be reliable leading indicators of economic activity. Although all measures are important, the reader will find that changes in the growth of the money supply provide the most reliable indication of future trends because of its long lead time in predicting changes in economic activity.

(From Chapter 4 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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