Saturday, May 19, 2007

What are the leading indicaters telling us?

In theory, so-called leading economic indicators are supposed to tell us the nature of economic strength in the months ahead. Sometimes they do, and sometimes they don't. Most so-called indicaters are problematic, and the so-called leading economic indicaters have their share of "issues." To wit, the Conference Board leading indicators this past week which which came in with a moderately negative reading of -0.5% simply seem dramatically out of whack with some of the actual recent economic data that seem more indicative of economic strength going forward. As a result, the best we can say about the Conference Board Leading Indicators is that they continue to bear watching, but they are not gospel, and we need to look elsewhere for true indications of the likely trajectory of the economy in the coming months.

 Here's what the Conference Board had to say about Leading Indicaters in April:

LEADING INDICATORS. Two of the ten indicators that make up the leading index increased in April. The positive contributors — beginning with the largest positive contributor — were stock prices and real money supply*. The negative contributors — beginning with the largest negative contributor — were building permits, average weekly initial claims for unemployment insurance (inverted), manufacturers' new orders for nondefense capital goods*, index of consumer expectations, vendor performance, average weekly manufacturing hours, and interest rate spread. The manufacturers' new orders for consumer goods and materials* held steady in April.

The leading index now stands at 137.3 (1996=100). Based on revised data, this index increased 0.6 percent in March and decreased 0.6 percent in February. During the six-month span through April, the leading index decreased 0.2 percent, with three out of ten components advancing (diffusion index, six-month span equals thirty percent.)

It is certainly true that having only 2 of 10 indicators up and 7 of 10 down is at least superficially very negative, especially in light of mixed and weak readings over the past six months, but there is more to the story than that.

Here are the specific 7 indicators that allegedly drag the Conference Board leading indicators into negative territory:

  1. building permits
  2. average weekly initial claims for unemployment insurance (inverted)
  3. manufacturers' new orders for nondefense capital goods
  4. index of consumer expectations
  5. vendor performance
  6. average weekly manufacturing hours
  7. interest rate spread

Yeah, building permits are certainly in the doldrums and unlikely to be offering significant economic strength in the months ahead.

Interest rate spread really isn't a leading indicater at all. Some people view a yield curve inversion as an indicator that a recession is coming, which sometimes does happen, but it really isn't a leading indicator of activity at all. Rather, low interest rates which can fuel economic growth are what matter. In times past, a positive yield curve did matter, but in today's world of private capital and a glut of capital, the spread between the yield on a 6-month T-bill and a 10-year Treasury note simply has virtually no impact on real economic activity.

Capital goods orders are extremely volatile on a monthly basis, so they don't work well at all as a leading inidicater on a monthly basis. Even if manufacturers' new orders for nondefense capital goods were down in April, the ISM manufacturing report for April showed a dramatic rise in orders, from 51.6 to 58.5, and the ISM non-manufacturing (services) report showed a modest rise as well, so the fact that the Conference Board indicators were down here is rather misleading about the big picture.

Weekly unemployment claims have actually declined in recent weeks, so this would be a positive factor rather than the negative factor we see in the April report. So, there is no negative leading indicator on this front.

Studies have shown that consumer confidence/sentiment is not a predictor of future consumer spending at all, and consumers themselves are unable to forecast the future any better than so-called "professional" economists, so consumer expectations also should not be included as part of a leading economic indicater. I have yet to encounter a sound argument for including this unreliable indicator as a leading economic indicator.

Given the extent to which services have overtaken manufacturing, it is certainly odd that average weekly manufacturing hours would still be considered a reliable component of a leading economic indicater index.

So, given the actual components of the Conference Board leading index, it is no surprise that it was so negative, but it also should not be considered a reliable indicater of future economic activity.

I much prefer the Weekly Leading Index (WLI) from the Economic Cycle Research Institute (ECRI). Being reported weekly, it gives you a clue based on the latest data. It also has a six-month smoothed growth rate index that shows more of the big picture. This index is currently indicating modest to moderate economic growth in the coming months, neither boom nor bust, and no sign of any impending recession of economic slump.

In short, overall, the so-called leading indicators are giving us mixed readings, but no confirmation of economic weakness in the months to come. If anything, they are merely telling us that we are simply not looking at a boom (e.g., no 4% GDP growth.)

-- Jack Krupansky

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