By Chris Stone
The third component of the Business Cycle Indicators (BCI) is the Composite Index of Lagging Indicators. This rarely cited but useful index is the final confirmation for economists and traders that the business cycle has made a shift into a new stage. The Composite Index of Lagging Indicators usually affirms a recent peak or trough in the economy as its signal comes well after a move in the stock market.
A divergence in the Composite Index of Lagging Indicators - which occurs when the Composite Index of Leading Indicators and Composite Index of Coincident Indicators make a top or bottom but the trend in the Index of Lagging Indicators is unaffected - can be a warning signal that the other components of the BCI missed important developments in the economy. Traders should proceed with caution until the Index of Lagging Indicators moves back into sync with the rest of the BCI.
The Methodology Like the Indexes of Leading and Coincident Indicators, the Index of Lagging Indicators is a composite of multiple economic measures. Specifically, it is made up of seven economic series that have historically registered a change in the business cycle after the change has already taken place. The seven lagging components are averaged to smooth their results, and adjusted for volatility with a standardization factor. The Conference Board (CB) releases the Index of Lagging Indicators together with the other two BCI indexes in a monthly press release - there is a different release date for each of the nine countries covered.
Below is a list of the seven components of the Composite Index of Lagging Indicators, according to the board's Business Cycle Indicators.
- Average duration of unemployment - This component represents the average number of weeks an unemployed individual has been out of work. The value of this component is inverted to indicate a lower reading during a recession and a higher reading during an expansion. The measure of duration of unemployment is a lagging indicator because the people have a harder time finding a job after a recession has already begun.
- Inventories-to-sales ratio (manufacturing and trade, in 1996 dollars) - The information for the inventory-to-sales ratio is constructed by the Department of Commerce's Bureau of Economic Analysis (BEA), and represents manufacturing, wholesale and retail-business data that comes from the department's Bureau of the Census. The ratio is adjusted for inflation. Increases in inventory generally mean sales estimates were missed, indicating a slowing economy. The inventory-to-sales sales ratio usually makes its peak in the middle of a recession, and continues to decline through the beginning of a recovery.
- Change in labor cost per unit of output (manufacturing) - This component is constructed by CB using various sources of employee compensation data in the manufacturing sector. The input values come from organizations such as the BEA and the Board of Governors of the Federal Reserve. The final number represents the rate of change in employment compensation compared to industrial output. Frequently, when the economy is in recession, industrial production slows faster than labor costs, which is why this measure is a lagging indicator - it usually peaks during a recession.
- Average prime rate (banks) - This component is compiled by the Fed's board of governors. Changes in the interbank loan interest rate tend to lag the overall economic activity because the Federal Open Market Committee sets this interest rate in response to economic growth and inflation. To stimulate growth, the federal funds rate will remain low for a period after the overall economy begins to recover from a contraction.
- Commercial and industrial loans outstanding (in 1996 dollars) - This component records the total amount of outstanding loans and commercial papers, adjusted for inflation. The data comes from the Fed's board of governors. Demand for loans tends to peak after the overall economy does because of the associated decline in corporate profits. This component lags an economic recovery by a year or more; its peaks and troughs form long after those of the general business cycle.
- Ratio of consumer installment credit to personal income - This ratio reflects the relationship between consumer debt and income. Again, this component's data comes from the Fed's board of governors. Consumer borrowing tends to lag improvements in personal income by many months because people remain hesitant to take on new debt until they are sure that their improved income level is sustainable. The lagging characteristic of this component's peaks is less predictable.
- Consumer price index (CPI) services - This component comes from the Bureau of Labor Statistics, and represents the inflation in consumer prices for service products. Price increases in consumer-related service products tend to occur in the early months of a recession, and subside at the start of a recovery. Since the CPI represents prices that have already changed, this component lags other economic indicators. While changes in the Treasury yield curve can be good predictors of future inflation, the CPI merely announces that inflation arrived - one month ago.
In the above chart, the three BCI Indexes are charted from Jul 1973 to Jan 2005. Remember, in the charts of any of the three BCI components, what matters most is where the peaks and troughs lie, not the long-term trend of the charts. In the chart above, the timing characteristics of the three BCI components are clear. Just as one would expect, the troughs come first in the Index of Leading Indicators (red line), followed by the Index of Coincident Indicators (blue line), and then the Index of Lagging Indicators (yellow). When the yellow line shows its bottom, traders should have no doubt that the economy has moved into a new stage.
Notice the horizontal nature of the Index of Lagging Indicators compared to the upward trend of the other two indexes. The combination of ratios and interest rates - typically range-bound measures - make this index of the BCI appear much like a sine wave. This is an appealing feature to traders and economists because it presents the business cycle in a detrend form.
The Index of Lagging Indicators is most useful when evaluated together with the other two BCI indexes. It is used primarily to confirm the direction of the economy that the leading and coincident indexes already signaled in the past. So if economists suspect that the economy has fallen into a recession, they can look to the Index of Lagging Indicators to verify their assessment and gauge how severe the recession is/was. The lagging component of the BCI is quite useful to researchers and economists, who are evaluating the past economic cycle to determine its beginning and ending date.
The Index of Lagging Indicators is not quite as useful for traders, but it does emit an important signal for them when it fails to confirm the direction of the leading and coincident measures of the BCI. Such divergence suggests there is an inconsistency in the economic data, which in turn could mean that the stock market has misinterpreted the direction of the economy. Traders should proceed with caution until the divergence is resolved.
The diffusion index, which measures the breadth of the movement in a BCI index (as discussed in chapters 3 and 4) can be applied to the lagging index as well. The diffusion index, indicating how many of the individual components of the index are moving with the overall index, helps economists measure the accuracy and severity of the index's values.
The three BCI indexes, when used together, give a composite reading of the overall economy, which is a powerful tool for traders, economists and business executives. The Composite Index of Lagging Indicators provides the important final piece to the overall picture, closing the book on a recession or recovery by confirming the direction of the other two BCI components. Successful traders will keep an eye on the BCI each month, using it to tailor their positions to the overall health and cyclical stage of the economy.
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