By Chris Stone
Using National Bureau of Economic Research (NBER) data in the 1930s, Arthur Burns and Wesley Mitchell, (as we discuss in the previous chapter 3) popularized the study of business cycles. Their early research led to the creation of the Business Cycle Indicators (BCI), which are now published by the Conference Board (CB) and composed of three indexes: the Composite Index of Leading Indicators (see previous chapter), the Composite Index of Coincident Indicators (explored here) and the Composite Index of Lagging Indicators (which we examine in the next chapter).
Just like the Composite Index of Leading Indicators, the Composite Index of Coincident Indicators comprises cyclical economic data sets - four in all. For the Coincident Index, components are chosen because they are generally in-step with the current economic cycle. The Conference Board, according to their 2004 report Using Cyclical Indicators, considers the coincident components a "broad series that measures aggregate economic activity; thus they define the business cycle".
For the Index of Coincident Indicators, four economic data series are averaged for smoothness, and the volatility of each is then equalized using a predetermined standardization factor (which the CB updates once a year). In 1996 the value of the BCI data was re-based to equal 100. The Index of Coincident Indicators is issued monthly in a press release along with the other BCI data.
The Four Components
- Employees on Non-Agricultural Payrolls - This component, also known as "payroll employment", is released by the Bureau of Labor Statistics. It does not discriminate between full-time, part-time, permanent or temporary workers. Because the data reflects actual changes in hiring and firing, this series is considered the most widely followed gauge of the health of the U.S. economy.
- Personal Income, Less Transfer Payments (in 1996 dollars) - This component is designed to include the value of all sources of income, adjusted for inflation, for the purpose of measuring the real salaries and other earnings of all people. Social Security payments are excluded. This measure of income adjusts wage accruals less disbursements (WALD) to smooth seasonal bonuses that can distort the wages on which earners base their purchase decisions. The personal-income component measures both the general health of the economy and aggregate spending.
- Index of Industrial Production - Output of gas and electric utilities, mining and manufacturing production are measured on a value-added basis. The data is collected from many industrial sources contributing values of shipments, employment levels and product counts. Historically, this value-added measure has captured most of the movements in total industrial output.
- Manufacturing and Trade Sales (in 1996 dollars) - This attempts to measure real total spending. The data comes from the National Income and Product Account calculations, which are prepared by the Department of Commerce's Bureau of Economic Analysis.
The blue line on the chart above represents the value for the Index of Coincident Indicators from Sept 1972 to Jan 2005. The red line represents the value of the Index of Leading Indicators. Both are re-based to average 100, representing the value of 1996.
The chart of the coincident indicators is essentially a map of the business cycle. It is particularly useful to traders who follow the theory of sector rotation because it helps them determine which stage the economy is currently experiencing. This in turn indicates which industries are likely to be most profitable at the time. (For further reading, see Sector Rotation: the Essentials.)
The vertical slant to the blue line is not as important as the peaks and troughs. Notice the peaks occur on the chart a few months after the peaks of the Index of Leading Indicators. These turning points represent the beginning of a new economic expansion or contraction, and confirm the earlier signal of the leading indicators.
An aggressive trader may act on the first or second major turning point exhibited by the Index of Leading Indicators, while more cautious traders might wait for the Index of Coincident Indicators to confirm the change. The aggressive trader risks being wrong, but the cautious trader risks missing the boat: stocks tend to anticipate changes in the business cycle three to six months in advance.
The Index of Coincident Indicators shares many of the same shortfalls that beset the Indexes of Leading and Lagging Indicators. Because some of the values of the components have to be estimated for the original release of the data, the numbers must be revised later when the real values are known. This makes on-the-spot interpretation tricky, because the historical data used to construct any interpretation is invariably altered later. But, even with this historical-revision drawback, the Index of Coincident Indicators provides an excellent benchmark for the current state of the economy and the current stage of the business cycle.
As mentioned above in the discussion of the chart, traders who follow the strategy of sector rotation - based on the idea that certain industries outperform others during specific stages of the business cycle - must constantly monitor the current state of the economy. These sector-rotation traders will look to coincident indicators for confirmation of the sector outperformance they have already seen in the stock market. After determining the current stage, these traders can begin to anticipate the next stage of the cycle by looking to the leading indicators, watching for trade setups in the relevant stocks. (Again, for more information on this style of trading, see Sector Rotation: the Essentials.)
In the previous chapter on the Composite Index of Leading Indicators, we mentioned the CB's diffusion index as a way to augment the signals from the BCI indexes. This diffusion index measures the breadth of a move in a BCI index by computing how many of its components are following the same movement. A sharp move in the composite index that is generated by a broad number of components in agreement (rather than just one or two components) is considered a stronger signal.
Traders can rely on the Composite Index of Coincident Indicators to determine the current stage of the business cycle. These indicators either confirm or contradict the current trend of the Composite Index of Leading Indicators as well as stock prices in general. Confirmation from the Composite Index of Coincident Indicators is a valuable sign that the current direction will remain intact, while a divergence should be met with caution. Downturns in the coincident components usually mean an impending downturn in the components of the Composite Index of Lagging Indicators, in which case traders should position their trades accordingly. Astute traders who learn to master the timing of leading, coincident and lagging signals gain great insight into profitable trading opportunities.
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