What Is a Leading Indicator?
A leading indicator is any measurable or observable variable of interest that predicts a change or movement in another data series, process, trend, or other phenomenon of interest before it occurs. Leading economic indicators are used to forecast changes before the rest of the economy begins to move in a particular direction and help market observers and policymakers predict significant changes in the economy.
Leading indicators can be useful to help forecast the timing, magnitude, and duration of future economic and business conditions. A leading indicator may be contrasted with a lagging indicator.
- A leading indicator is a piece of economic data that corresponds with a future movement or change in some phenomenon of interest.
- Economic leading indicators can help to predict and forecast future events and trends in business, markets, and the economy.
- Different leading indicators vary in their accuracy, precision, and leading relationships, so it is wise to consult a range of leading indicators in planning for the future.
- The index of consumer confidence, purchasing managers' index, initial jobless claims, and average hours worked are examples of leading indicators.
Understanding Leading Indicators
Leading indicators must be measurable in order to provide hints as to where the economy is headed next. Investors use these indicators to guide their investment strategies as they anticipate future market conditions. Policymakers and central bankers use them when setting fiscal or monetary policy. Businesses use them to make strategic decisions as they anticipate how future economic conditions may affect markets and revenue.
Leading indicators are often based on aggregate data gathered by respected sources and focused on specific facets of the economy. For example, economists closely watch the Purchasing Managers Index (PMI) in order to predict growth in a nation’s gross domestic product (GDP) due to changes in the demand for materials from corporations.
Durable goods orders is instead based on a monthly survey of industrial manufacturers. It specifically measures the health of the durable goods sector. Similarly, many people consider the Consumer Confidence Index (CCI) to be among the most accurate leading indicators. This index surveys consumers about their own perceptions and attitudes about the economy and where it is going.
Leading Indicators for Investors
Many investors will pay attention to the same leading indicators as economists, but they tend to focus on those indicators directly related to the stock market.
One example of a leading indicator of interest to investors is the number of jobless claims. The U.S. 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 will likely have a negative effect on the stock market. If jobless claims fall, this may indicate that companies are growing, which is a good indication for the stock market.
As another example, many market participants consider the yield curve, specifically, the spread between two-year and 10-year Treasury yields, a leading indicator. This is because two-year yields in excess of 10-year yields has been correlated with both recession and short-term market volatility.
Leading Indicators for Businesses
All businesses track their own bottom lines and their balance sheets, but the data in these reports is a lagging indicator. A business’ past performance does not necessarily indicate how it will do in the future.
Instead, businesses look at performance—such as customer satisfaction—as indicators of future revenues, growth, or profits. For example, customer complaints or negative online reviews often indicate problems related to production or service, and in some industries, may signal lower future revenue.
Accuracy of Leading Indicators and How to Use Them
Leading indicators are not always accurate. However, looking at several leading indicators in conjunction with other types of data can help provide information about the future health of an economy.
Leading indicators often face trade-offs between accuracy, precision, and lead time in predicting future events. While an ideal leading indicator would predict changes in economic trends or business performance accurately, within a narrow range of estimates and over a long time-horizon, in practice, all leading indicators show variable performance along these dimensions.
As a hypothetical example, with respect to the U.S. economy, capital goods new orders data can provide a far advance warning of downturns in the economy (long lead time), but the historical lead time between turning points in capital goods and a specific target indicator such as stock prices or GDP may range from 12 to 24 months (low precision), and the magnitude of changes in capital goods new orders might not bear any consistent relationship with the size of changes in GDP (inaccurate except as an indicator of timing). This indicator would be useful as a long-term warning sign, but would not support a precise estimate of the timing or size of future trends.
On the other hand, a leading indicator might 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 would provide detailed input into estimating the trends that impact your business or investments, but might not provide that information in sufficient time to take full advantage of the insight gained.
By themselves, both types of leading indicators might be helpful, but neither provides the full 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 forward-looking can provide the best opportunity to capitalize on future trends.