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By Chris Stone
The purpose of the Board's Business Cycle Indicators (BCI) is to provide ways for analyzing the expansions and contractions of the economic cycle. The Composite Index of Leading Indicators is one of three components of the BCI - the other two are the Composite Index of Coincident Indicators and the Composite Index of Lagging Indicators.
Since the leading-indicators component attempts to judge the future state of the economy, it is by far the most widely followed. But before we explore its components and the ways in which it is interpreted, let's take a look at some background of the overall BCI.
Early History of Business Cycle Indicators
After the disaster of the Great Depression, economists were eagerly searching for ways to detect the next economic downturn. The development of the BCI started in the 1930s as Arthur Burns and Wesley Mitchell of the National Bureau of Economic Research (NBER) began experimenting with the patterns showing up in the NBER's data. They called these patterns business cycles, and in their 1946 book "Measuring Business Cycles" described them as: "consist of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle".
This early research represents the beginning of the study of the business cycle by means of economic indicators. Much of the following development of this 'indicator approach' was pursued at the NBER under the supervision of Dr Geoffrey Moore, an economics researcher who developed the concept of leading, lagging and coincident business-cycle indicators, and is still considered the "father of the leading indicators".
By the late 1960s, the U.S. Department of Commerce was producing material resembling the model for the Board's current BCI. The CB became the official publisher of the BCI, taking over from the government, in Dec 1995. Today, it releases the BCI for Mexico, France, the United Kingdom, South Korea, Japan, Germany, Australia, Spain and, of course, the United States.
Methodology Behind Indexes of the BCI
The three BCI indexes are called composite indexes because they incorporate multiple data components. According to their report Using Cyclical Indicators (2004), the Board makes six considerations when choosing an appropriate cyclical component for any index. These six considerations are carried about with the following six statistical and economic tests:
- Conformity - The data series must conform consistently in relation to the business cycle.
- Consistent timing - The series must exhibit a consistent timing pattern as a leading, coincident or lagging indicator.
- Economic significance - Its cyclical timing must be economically logical.
- Statistical adequacy - The data must be collected and processed in a statistically reliable way.
- Smoothness - Its month-to-month movements must not be too erratic.
- Currency - The series must be published on a reasonably prompt schedule, preferably every month.
So, since few single components meet all six criteria, the Conference Board compiles multiple components into each of the indexes of the BCI.
Methodology of the Index of Leading Indicators
The Index of Leading Indicators incorporates the data from 10 economic releases (which we review below) that traditionally have peaked or bottomed ahead of the business cycle. The exact formula for calculating changes in the leading index is rather involved but not necessary for understanding the indicator from our perspective here. (However, if you are interested, the formula can be found here on the Board's website).
Each of the 10 components is averaged, and a standardization factor is applied to equalize volatility. (You can find the current standardization factors here.) In 1996 the value of the Index of Leading Indicators was re-based to represent the average value of 100, and the CB releases the data on a monthly basis. Below are the ten components that make up the composite indicator (charts of each component can be found here).
The 10 Components
- Average weekly hours (manufacturing) - Adjustments to the working hours of existing employees are usually made in advance of new hires or layoffs, which is why the measure of average weekly hours is a leading indicator for changes in unemployment.
- Average weekly jobless claims for unemployment insurance - The CB reverses the value of this component from positive to negative because a positive reading indicates a loss in jobs. The initial jobless-claims data is more sensitive to business conditions than other measures of unemployment, and as such leads the monthly unemployment data released by the Department of Labor.
- Manufacturer's new orders for consumer goods/materials - This component is considered a leading indicator because increases in new orders for consumer goods and materials usually mean positive changes in actual production. The new orders decrease inventory and contribute to unfilled orders, a precursor to future revenue.
- Vendor performance (slower deliveries diffusion index) - This component measures the time it takes to deliver orders to industrial companies. Vendor performance leads the business cycle because an increase in delivery time can indicate rising demand for manufacturing supplies. Vendor performance is measured by a monthly survey from the National Association of Purchasing Managers (NAPM). This diffusion index measures one-half of the respondents reporting no change and all respondents reporting slower deliveries.
- Manufacturer's new orders for non-defense capital goods - As stated above, new orders lead the business cycle because increases in orders usually mean positive changes in actual production and perhaps rising demand. This measure is the producer's counterpart of new orders for consumer goods/materials component (#3).
- Building permits for new private housing units - Building permits mean future construction, and construction moves ahead of other types of production, making this a leading indicator.
- The Standard & Poor's 500 stock index - The S&P 500 is considered a leading indicator because changes in stock prices reflect investor's expectations for the future of the economy and interest rates. The S&P 500 is a good measure of stock price as it incorporates the 500 largest companies in the United States.
- Money Supply (M2) - The money supply measures demand deposits, traveler's checks, savings deposits, currency, money market accounts and small-denomination time deposits. Here, M2 is adjusted for inflation by means of the deflator published by the federal government in the GDP report. Bank lending, a factor contributing to account deposits, usually declines when inflation increases faster than the money supply, which can make economic expansion more difficult. Thus, an increase in demand deposits will indicate expectations that inflation will rise, resulting in a decrease in bank lending and an increase in savings.
- Interest rate spread (10-year Treasury vs. Federal Funds target) - The interest rate spread is often referred to as the yield curve and implies the expected direction of short-, medium- and long-term interest rates. Changes in the yield curve have been the most accurate predictors of downturns in the economic cycle. This is particularly true when the curve becomes inverted, that is, when the longer-term returns are expected to be less than the short rates.
- Index of consumer expectations - This is the only component of the leading indicators that is based solely on expectations. This component leads the business cycle because consumer expectations can indicate future consumer spending or tightening. The data for this component comes from the University of Michigan's Survey Research Center, and is released once a month.
The yellow line on the chart below represents the value of the CB's Index of Leading Indicators from Aug 1972 to Dec 2005 with the range of values from 72 to 116 (normalized in 1996 to equal 100).
The chart shows that the Index of Leading Indicators began its decline in the first month of 1973, and (separate) data from the NBER suggests that the U.S. economy was contracting from Nov 1973 until Mar 1975. A similar period of contraction occurred from July 1981 through Nov 1982, and, again, the Index of Leading Indicators had put in a top well ahead of the overall business cycle.
The upward drift of the chart is less relevant than the location of the peaks and troughs, as they are the formations that signal changes in the business cycle.
There is a rule of thumb that states that three consecutive declines in the Index of Leading Indicators over three months signals a coming recession. Unfortunately, this rule is far too rigid to work routinely in real life: this three-steps-down technique has emitted at least one false signal in six of the eight expansions that came before Feb 2005. Thus, some economists, before anticipating a recession, prefer to see a sharp, prolonged decline (of more than 1%) in the leading index, accompanied by broad-based declines in the 10 components. In fact, many people have found that the breadth of the decline - that is, how many of the 10 components are declining - is as important as the depth.
For this reason, economists often refer to the CB's diffusion index when judging the moves in the leading index. The diffusion index can measure the breadth of a move in any BCI index, showing how many of an index's components are moving together with the overall index. Here are the steps involved in the way the Conference Board constructs the diffusion index for the BCI series:
So, applied to the leading index, the diffusion index simply represents how many of the 10 components are moving in agreement with the overall leading index. Here's a quote from the CB's report Using Cyclical Indicators (2004), which provides one way to interpret the Index of Leading Indicators with the diffusion index:
|"Even though the composite leading index has flaws, and is not 100 percent reliable, it can be used along with the corresponding diffusion index to give useful signals about the likely direction of the economy. Historical analysis shows that a negative growth rate over a six-month period of between 1 to 2 percent for the leading index and declines in at least half of the components (i.e. the six-month diffusion index falling below 50 percent) is a reasonable criteria for a recession warning."|
Challenges of Forecasting
In some people's opinion, the Conference Board's Composite Index of Leading Indicators has been, at best, a marginal predictor of economic downturns. The historical data is often revised later, leaving the chart you see today different than the one you would see later when making trading decisions based on your initial interpretation. Any attempt to forecast a coming downturn in the economic cycle meets with a host of problems. Even after the fact, economists argue over whether a recession has occurred or, if they agree on that, they argue over when it began and ended.
For traders making a prediction amidst an atmosphere of uncertainty is a daunting proposition. However, while economists argue over the accuracy of the above indicators, there is no denying that these indicators do have attributes which lead the overall economic cycle and therefore poses some usefulness.
Here are the websites of the three economic research organizations we refer to:
-The Conference Board: http://www.conference-board.org
-The National Bureau of Economic Research: http://www.nber.org
-The Economic Cycle Research Institute: http://www.business cycle.com
Next: Conference Board: Composite Index Of Coincident Indicators »
Table of Contents
- Conference Board: Introduction
- Conference Board: What Is It?
- Conference Board: Composite Index Of Leading Indicators
- Conference Board: Composite Index Of Coincident Indicators
- Conference Board: Composite Index Of Lagging Indicators
- Conference Board: Help-Wanted Advertising Index
- Conference Board: CEO Confidence Survey
- Conference Board: Consumer Confidence Index
- Conference Board: Consumer Internet Barometer
- Conference Board: Conclusion
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