In the spring of 1989 two economists, James S. Stock and Mark W. Watson, published a paper entitled, “Indexes of Coincident and Leading Indicators” in the NBER Reporter. In this paper the two economists proposed a different approach in computing economic indicators. They selected them solely on the basis of their reliability. The experimental coincident index is a weighted average of broad monthly measures of U.S. economic activity. These measures are:
1. Industrial production
2. Total personal income, less transfer payments adjusted for inflation
3. Total manufacturing and trade sales adjusted for inflation
4. Total employee hours in non-agricultural establishments
These measures, as we discussed above, represent what is happening in the economy at any particular point in time, and reflect the strengths and weaknesses of the overall economy. The weighted average to compute the Experimental Coincident Index is computed using current and recent values of the growth rates of these four series. This weighted average in growth rates is then cumulated to create an index in levels. This index was constructed so that it equaled 100 in July 1967. The average monthly rate of growth in the experimental coincident index is 3% at an annual rate. Thus, the experimental coincident index has approximately the same trend growth rate as real GDP, which grew at an average rate of 3.1% from 1960 to 1988. The experimental coincident index is approximately 1 to 1-1/2 times more volatile than real GDP.
The experimental leading index proposed by Stock and Watson is a forecast of the growth of the experimental coincident index over the next six months (that is, for the six months subsequent to the month for which the data are available). The forecast is stated in percentage terms on an annual basis. Thus, for example, the experimental leading index for April represents a forecast of the percent growth in the experimental coincident index between April and October at annual rates.
The experimental leading index is a weighted average of seven leading indicators:
1. Building permits for new private housing
2. Manufacturers and field orders in the durable goods industry, adjusted for inflation
3. Trade weighted index of nominal exchange rates between the U.S. and the U.K., Germany, France, Italy, and Japan
4. Number of people working part-time in non-agricultural industries because of slack work
5. The yield on a ten-year U.S. Treasury bond
6. The difference between the interest rates on 3-month commercial paper and the interest rates on 3-month U.S. Treasury Bills
7. The difference between the yield on a 10-year U.S. Treasury bond and the yield on 1-year U.S. Treasury bond
Stock and Watson developed another indicator called the experimental recession index. The experimental recession index is an estimate of the probability that the economy will be in a recession six months from the date of the index. For example, the experimental recession index for April gives the probability that the economy will be in a recession in October. The experimental recession index is computed using four monthly series in the experimental coincident index and the seven monthly series in the experimental leading index.
The experimental recession index represents a probability. For example, if the experimental recession index is 25%, then the probability of the economy being in a recession in six months is 25%. The lowest possible value of the experimental recession index is 0% and the highest is 100%.
Since the experimental leading index was too dependent on financial information, Stock and Watson developed an alternative experimental recession index. This index is an alternative experimental recession index based on seven leading indicators that exclude interest rates and interest rate spreads. The method used to construct the alternative experimental recession index is the same as the experimental recession index. The difference between the two is the underlying series to construct the two indices. The seven series used in the alternative experimental recession index are:
1. Building permits for new private housing
2. Manufacturers and field orders for durable goods industries, adjusted for inflation
3. Trade weighted index of nominal exchange rates between the U.S. and the U.K., Germany, France, Italy and Japan
4. Index of help-wanted advertising in the newspapers
5. Average weekly hours of production workers for durable goods industries
6. Percent of companies reporting slower deliveries, as determined by the National Association of Purchasing Manager
7. Capacity utilization rate in manufacturing
The two economists publish the latest information on these indicators on their website (HTTP://www.KSGHOME.Harvard.edu) For more detail and discussion on how these indicators are computed and how they are used, the reader is referred to their original paper published in the spring of 1989 in the NBER Reporter.
Although not used in either The Conference Board or the Stock-Watson indicators, the ratio between BAA bond yields and 10-year Treasury bond yields is also an excellent leading indicator. This ratio is very closely correlated with the growth in the money supply and stock prices. Because of this cyclical timing, it has an important strategic value when used in conjunction with other business cycle indicators.
(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.
2009 Market Timer of the Year by Timer Digest
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