Definition and how it is used by investors

What is a leading indicator?

A leading indicator is a measurable set of data that can help predict future economic activity. Leading economic indicators can be used to predict changes in the economy before the economy begins to move in a particular direction. They have the potential to be useful to businesses, investors and policy makers.

Leading indicators are one of three main types of indicators. The other two are lagging indicators and coincident indicators.

Understand leading indicators

Leading indicators must be measurable to be useful as predictors of where the economy may be headed. Policymakers and central bankers use leading indicators when setting fiscal or monetary policy. Businesses study it to anticipate the effect of future economic conditions and then make strategic decisions regarding markets and revenues.

All businesses track their own results and balance sheets, but such data are lagging indicators, meaning they are produced by events that have already happened. It is important that a business’ past performance does not necessarily indicate how it will do in the future.

Investors use leading indicators to guide their investment strategies as they try to anticipate market conditions. Many focus on those indicators that are directly related to the stock market. This can include the housing market, retail sales, building permits, business startups, and more.

Examples of leading indicators

Purchasing Managers’ Index

Economists keep a close eye on the purchasing managers’ index (PMI). The PMI reflects trends in the manufacturing and service sectors and can be a useful sign of growth in a country’s gross domestic product (GDP) due to changes in material demand from corporations.

Durable Goods Orders

Durable goods orders are a monthly survey of manufacturers produced by the US Census Bureau. It measures industrial activity in the durable goods sector and the state of the supply chain.

Consumer Confidence Index

Along with durable goods orders, many people consider the Consumer Confidence Index (CCI) to be one of the most accurate leading indicators. This index surveys consumers about their attitude towards the economy and their perceptions of economic activity going forward.

Jobless claims

The US Department of Labor provides a weekly report on the number of jobless claims as an indicator of the economy’s health. A rise in jobless claims indicates a weakening economy, which can have a negative effect on the stock market. A drop in jobless claims could indicate that companies are growing (and hiring), which could be positive for the stock market.

Yield curve

Many market participants view the yield curve as a leading indicator. Of particular interest is the difference between two-year and 10-year Treasury yields. This is because two-year returns are correlated more than 10-year returns with both recession and short-term market volatility. If such an inverted yield curve occurs, it may indicate that a recession is approaching.

Company performance

Although not a measure issued by economists or government agencies, customer complaints or negative online reviews can be seen as a leading indicator of customer satisfaction that may indicate problems with a business’s product quality or service failures. This may indicate lower future income, growth or profits. Conversely, positive customer satisfaction data may indicate that these factors will trend upward in the future.

Accuracy of leading indicators and how to use them

Conflicting signals

Leading indicators are not always accurate. However, looking at various leading indicators in conjunction with other types of data can provide useful information about the future health of an economy.

An ideal leading indicator would accurately predict changes in economic trends or business performance, within a narrow range of estimates, and over a large time horizon. In practice, however, all leading indicators show variable performance along these lines.

For example, the advance warning of economic downturns provided by data on new orders for capital goods can provide a long time for action. However, the historical lead time between turning points in capital goods and a specific target indicator such as changing stock prices or GDP can vary from 12 to 24 months. You end up with data that indicates a long time to action, but low precision about when to take it.

What’s more, the magnitude of changes in new orders for capital goods may not have any consistent relationship with the magnitude of changes in GDP, making it imprecise except as an indicator of timing. Therefore, this indicator will be useful as a long-term warning sign, but it will not support an exact estimate of the timing or magnitude of future trends.

On the other hand, a leading indicator can give highly accurate and precise information about a turning point or trend in the market or the economy, but only over a few months or quarters. Such an indicator can provide detailed input for estimating the trends affecting your business or investments. But it may not provide that information in time to take full advantage of the insight gained.

By themselves, both types of leading indicators can be useful. Yet neither provides the complete picture needed to maximize performance. In practice, this means that using a range of different leading indicators that are more or less accurate, precise and predictive can provide the best opportunity to capitalize on future trends.

Leading indicators vs. Lagging indicators

Leading indicators are used to predict future economic performance. Lagging indicators are data that reflect past economic performance. They are used to confirm economic change and financial market patterns.

Leading indicators

Measurable data that can indicate a potential upcoming change in the economy before it happens. They can alert users to specific economic changes and/or changing trends. Used by economists, analysts, businesses and investors to predict and take action before economic/financial changes. Not always accurate and can be improved when studied with other economic data. They are based on data related to the activities of different areas of the economy.

Lagging indicators

Measurable data that reflects the effects of economic activity after it has occurred. They can confirm for users certain economic and business trends, quality of performance and the impact of business decisions. Used by government, businesses and investors to determine future strategies as they relate to proven (or unproven) assumptions and expectations. Data is considered reliable. It is based on facts and financial outcomes related to economic activities previously took place.

The Bottom Line

Leading indicators have the potential to be a highly valuable tool for economists, investors, business owners and consumers. When used properly, they can indicate upcoming changes and broad trends in the economy.

However, the economy is not guaranteed to behave as leading indicators suggest, and it is crucial that you know which indicators are best to evaluate and how to use them properly.