The system of leading, coincident and lagging indicators allows the investor to follow the progress of the business cycle through its various phases. It also provides an important way to assess the risks and opportunities offered by various assets. When we discussed the indicators above, it became clear that an increase in the index of leading indicators - for instance, growth in the money supply, orders, building permits or profits - is followed after several months by an increase in the coincident index - for instance, production, employment, and income.
A protracted and strong increase in the coincident index is followed by an increase in the lagging index - that is inflation, labor costs and interest rates - a sign the economy is strong, is working close to full capacity and price and cost pressures are intensifying.
The length and volatility of the business cycle, and therefore, the investment risk, depends on how rapidly and how soon the lagging indicators rise. The reason is that a rise in the growth of the lagging indicators is followed after several months by slower growth in the leading indicators. For instance, an increase in interest rates makes the building and purchase of real estate more expensive, and therefore discourages the development of this sector. This is a typical example of a rising lagging indicator, such as interest rates, followed by a slower growth in a leading indicator, such as housing starts or building permits.
The same applies to profits. An increase in costs has an almost immediate negative impact on profits, forcing profits to slow down. Or, a rise in interest rates is followed by a slowdown in the money supply or stock prices. Eventually, the slowdown in the leading index causes, after several months, a slowdown in the index of coincident indicators. The point is that these three types of indicators (leading, coincident and lagging) are closely interconnected between themselves by very precise and logical relationships.
Only after a protracted slowdown in the coincident indicator, does the index of lagging indicators begin to decline. A peak in the growth of the lagging indicators follows a protracted slowdown in the coincident indicators. The reason is that the economic slowdown expands to various sectors of the economy. As a result, unemployment rises, labor becomes more available, and wages slow down. On the other hand, because of slower economic growth, demand for money declines and interest rates also decrease.
A few months following a decline of the index of lagging indicators the index of leading indicators rises again. The reason is that the decline in costs (wages and interest rates) makes it attractive again to invest in a new house, or to build new productive capacity. The money supply accelerates in response to increased demand for funds due to the decline in interest rates and stock prices rise.
The importance of the system of leading coincident and lagging indicators is that they are closely tied together (Fig. 4-1 and Fig. 4-2). The lagging indicators are the most relevant ones because an increase in the lagging indicators forewarns the investors and the businessperson that the leading index will decline and the economy will eventually worsen. On the other hand, a decline in the lagging index tells the investor and businessperson that the leading indicators will soon rise and that business condition will improve.
We mentioned above that the S&P 500 index, which is an index used to measure stock market performance, is a component of the index of leading indicators. We also have shown how short-term and long-term interest rates are lagging indicators. As we mentioned above, the stock market is a leading indicator of the business cycle because it reflects the liquidity available in the system.
Since the stock market is a leading indicator, its risk decreases when the index of lagging indicators, for instance, inflation, short-term and long-term interest rates, decrease or remain stable. This is good time to be in stocks. However, the odds favor a peak in the stock market when inflation, short-term or long-term interest rates begin to rise.
The financial cycle that took place from about 1990 to 1995 can also be used to explain the relationship between leading, coincident, and lagging indicators.
This chart shows how a peak in the leading indicator is followed by a peak in the coincident indicator, which is then followed by a peak in the lagging indicator. A peak in the lagging indicator is then followed by a trough in the leading indicator, which is then followed by a trough in the lagging indicator. And the cycle starts all over again. Note the negative feedback induced by the rise in the lagging indicator. The importance of the negative feedback is in its impact on measuring stock market risk and predicting its important peaks.
This is a different way of representing Figure 4-1. It also emphasizes that a leading indicator is predicted by using a lagging indicator, a coincident indicator by a leading indicator, and a lagging indicator by a coincident indicator. In 1989 the growth of the money supply began to expand rapidly (the growth of the money supply is a leading indicator). This was also the time when stock prices bottomed and started to grow faster. The index of industrial production began to grow faster in 1991 due to the generous injection of liquidity in the economic system. The economy strengthened and in 1994 interest rates began to rise because of the very strong growth of the economy. The increase in interest rates (a lagging indicator) was followed by a slowdown in the growth of the money supply and also a decline in the growth of stock prices. The financial cycle ended in 1995 when the protracted decline in the money supply, going from 1992 to 1995, caused the economy to slow down in 1995. A new financial cycle began in 1995.
The decline in stock prices (a leading indicator) is followed by a slowdown in the economy and eventually by a decline in the lagging indicators and a decline in interest rates (a lagging indicator). A decline in interest rates cannot take place without a protracted weakness in stock prices. Stock prices will start rising again after a few months of declining interest rates (lagging indicators). In other words, it takes a few months from a peak in interest rates to a bottom in stock prices and several months from the trough in interest rates to a peak in stock prices.
The importance of the system of leading, coincident, and lagging indicators is that it ties together business and financial indicators. Their relationship is a very important tool to determine the level of risk for investors in the financial markets.
The basic relationships can be summarized as follows:
• An increase in the growth of a leading indicator (for example: money supply) is followed after about two years by an increase in the growth of the coincident indicator (for example: industrial production).
• A prolonged increase in industrial production is followed after 1-1/2 to 2 years by an increase in the lagging indicators (for example: interest rates).
• An increase in the growth of lagging indicators is followed after several months by a peak in the growth of the leading indicators (for example: money supply).
• The decline in the growth of the leading indicators (for example: money supply) is followed after about 1-1/2 to 2 years later by a decline in the growth of the economy (for example, industrial production).
• A decline in the growth of industrial production is followed after several months by a decline in the growth of the lagging indicators (for example: interest rates).
• A decline in the growth of the lagging indicators (for example: interest rates) is followed after a few months by a rise in the growth of the leading indicators (for example: money supply).
And the business and financial cycles start all over again.
(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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