The composite index of lagging indicators is constructed by averaging individual components that historically followed the turning point of the coincident index. This gauge is probably the most important of the three indicators because it provides information about the degree of excesses that there are in the economic system. The growth of the index of lagging indicators has the property of increasing when the economy is growing rapidly, usually above its long-term average growth rate of 2.5 - 3.0%.

The indicators used in the computation of the Index of Lagging Indicators are:

1. Average duration of unemployment
This series measures the average duration in weeks that individuals counted as unemployed have been out of work. Because this series tends to be higher during recessions and lower during expansion, it is inverted in the computation of the index. In other words, the signs of the month-to-month changes are reversed. Decreases in the average duration of unemployment invariably occur after an expansion gains strength, and the sharpest increases tend to occur after a recession has begun. Therefore, sharp decreases in average duration of unemployment suggest the economy is overheating and investors have to begin to be cautious. On the other hand, a sharp increase in the average duration of unemployment is a sign that the economy has been slowing down quite sharply, and therefore, the excesses of the previous cycles are being corrected.

2. Inventories-to-sales ratio, manufacturing and trade inventories to sales
The ratio of inventories-to-sales is a popular gauge of business conditions for individual firms, entire industries, and the whole economy. This series is calculated by the Bureau of Economic Analysis using inventory and sales data for manufacturing, wholesale, and retail business. The data are used in an inflation-adjusted form, and they are based on information collected by the Bureau of the Census. Because inventories tend to increase when the economy slows down and sales fail to meet projections, the ratio typically reaches its cyclical peaks in the middle of a recession. It also tends to decline in the beginning of an expansion as firms meet their sales demand from excess inventories.

3. Change in labor costs per unit of output in manufacturing
This series measures the rate of change in an index that rises when labor costs for manufacturing firms rise faster than their productivity, and vice versa. The index is constructed by The Conference Board from various components, including seasonally-adjusted data on employee compensation in manufacturing, which includes wages and salaries plus any supplements. These data are available from the Bureau of Economic Analysis and are seasonally-adjusted data on industrial production in manufacturing from the Board of Governors of the Federal Reserve system. The data are seasonally-adjusted to eliminate distortion due to seasonality in the series. Because the monthly rate of change in this series is extremely erratic, percent in change in labor costs is calculated over a six-month span. Cyclical peaks in the six-month rate of change typically occur during a recession, as output declines faster than labor costs, despite layoffs of production workers.

Troughs in the series are much more difficult to determine and to characterize. The typical behavior of this series is that as the economy slows down and employment declines, and growth in wages and labor costs tends to decline. Therefore, this series declines following a decline in economic conditions or a decline in the growth of the index of coincident indicators. On the other hand, protracted growth in the coincident indicators is followed after one to two years by an increase in the growth of labor costs, due to the low availability of labor.

4. Average prime rate charged by banks
Although the prime rate is considered the benchmark the banks use to establish their interest rates for different types of loans, changes tend to lag behind the movements of general economic activity. The monthly data are compiled by the Board of Governors of the Federal Reserve system. There is no doubt that interest rates are one of the most important components of the index of lagging indicators because they measure the cost of credit. Although in the index of lagging indicators the prime rate is used, in later chapters we will discuss other interest rates that respond much quicker to changes in market conditions, such as the rate on 13-week Treasury bills or interest rates tied to Treasury bond yields.

5. Commercial and industrial loans outstanding
This series measures the volume of business loans held by banks and commercial paper issued by non-financial companies. Commercial paper is high grade unsecured notes sold through dealers by major corporations. They basically represent IOUs of major corporations. The underlying data are compiled by the Board of Governors of the Federal Reserve system. The Conference Board makes price level adjustments using inflation information based on personal consumption expenditures, which are the same that are used to deflate the money supply data in the leading index. This series tends to peak after an expansion peaks because declining profits usually place downward pressure on the demand for loans. Troughs are typically seen more than a year after the recession ends.

6. Consumer installment credit outstanding to personal income ratio
This series measures the relationship between consumer debt and income. Consumer installment credit outstanding is compiled by the Board of Governors of the Federal Reserve system and personal income data are from the Bureau of Economic Analysis. Because consumers tend to hold off personal borrowing until months after a recession ends, this ratio typically shows a trough after personal income has risen for a year or longer. The peak in this ratio follows a peak in the general economy.

7. Consumer price index for services
This series is compiled by the Bureau of Labor Statistics and measures the rate of change in the services component of the consumer price index. Inflation declines following a prolonged period of slower growth in the overall economy and in the index of coincident indicators, and it rises about two years after an increase in the growth of the economy and in the index of coincident indicators.

There is little doubt that the index of lagging indicators is the most misunderstood index and the press and investors pay little attention to its trend. After all, why pay attention to an indicator that rises after the economy is already in full swing? Or declines following a peak in overall economic conditions? Why should anyone pay attention to an indicator that is the result of what has happened? However, the index of lagging indicators and all of its components are the most important information available to investors. They are the most important gauges to assess the health of the economy and of the financial markets. Their trends represent a valuable tool available to investors to assess the risks induced by the business cycle on the financial markets. We are going to explore the main reasons why they have these important features.

As we said above, the index of lagging indicators lags trends in business activity. Let’s see why. Let's take, for instance, interest rates. Interest rates tend to decline after the economy slows down quite dramatically and they rise following a period of strong economic growth. The main reason is that as the economy grows rapidly so does the need to borrow in order to invest in an expanding capacity and to hire people. This increased borrowing activity eventually places upward pressure on interest rates. This is why the rise in interest rates lags trends in business activity. The main reason is that aggressive borrowing is done after business recognizes that the economic expansion has staying power. The same can be said when the economy weakens. Once business recognizes economic activity is deteriorating, they start borrowing less and interest rates decline.

Another component of the index of lagging indicators is unit labor costs - that is the cost of labor adjusted for productivity. This gauge also rises after the economy is well underway and strong. At the beginning, when the business cycle goes from a slow period to a strong period, there is a lot of labor available to be hired, productivity is high and wages are low, therefore, labor costs decline and remain stable. But as the labor supply decreases because more and more people have been hired, there is an increasing upward pressure on wages. These are also times when capacity utilization is high and productivity declines as a result of lower margin of productivity capacity available. Productivity is a measure of economic efficiency, which shows how effectively economic inputs are converted into output. The most commonly used measure of productivity is output per hour of all persons. If productivity grows, for instance, at 4% and wages are growing at 5%, labor costs adjusted for productivity is just 1%. As a result, lower growth in productivity has a negative impact on labor costs. Lower growth in productivity and higher wages place upward pressure in unit labor costs, which rise well after the business cycle is growing rapidly.

These simple examples show that the lagging indicators reflect excesses in the economy and lag economic conditions at peaks and troughs in business activity. If the economy expands too strongly and there are some imbalances created by the way the economy is growing, then the index of lagging indicators starts rising. If, on the other hand, the economy slows down and slack is built into the system, then the lagging indicators eventually decline.

The index of lagging indicators is very important because is rises when the economy is beginning to operate at such high levels that is producing strains on costs. A rise in the index of lagging indicators suggests that the economy is very strong and that there are strong cost pressures in the system. Rising cost pressures have two major impacts. The first one is to have a negative impact on the profitability of corporations. The second impact is that as business sees costs rising, they will try to pass these cost increases to consumers. The outcome of this is increased inflation at the consumer level and downward pressure on real income and consumer purchasing power. An increase in the index of lagging indicators is, therefore, a sign that there are major changes taking place in business; changes that have a negative impact for business and consumers.

Later in the chapter we will explore the strategic use of these indicators to determine the conditions of the business cycle.

(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

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

Shouldn't you too subscribe to The Peter Dag Portfolio?

No comments: