The Real Indicator to Watch

12/06/2012 9:15 am EST

Focus: MARKETS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

With all the indicators and indexes and chatter out there, it's extremely helpful to have one indicator that can help guide your investment decisions reliably, and this one does just that, explains Elliott Gue of Energy and Income Advisor.

Released on the third Thursday of each month, the Conference Board’s Index of Leading Economic Indicators (LEI) comprises ten components that tend to predict the direction of the economy.

1. Average Weekly Hours, Manufacturing (Index Weight: 0.2781)
Manufacturers hesitate to lay off workers at the first sign that demand has weakened, preferring to limit overtime or reduce the number of shifts that employees work. Not only does such a move entail significant costs and hit employee morale, but this drastic measure could also be for naught if the slowdown in demand proves temporary. For similar reasons, manufacturers usually increase employees’ weekly hours at the first sign of a pick-up in demand.

This leading indicator weakened in early 2008, presaging the economic collapse that occurred later that year. Average weekly hours in the manufacturing sector also started to recover in early 2009, months before the US exited recession.

With employees in the US manufacturing sector working longer hours than before the Great Recession, companies appear to be squeezing as much productivity out of their existing workforce because of uncertainty surrounding future growth.

2. Average Weekly Initial Claims for Unemployment (Index Weight: 0.0334)
Commentators often discuss the unemployment rate, or the percentage of the labor force that’s seeking work but has yet to find employment. Though important, trends in this data series historically have lagged the economy by several months.
 
For example, the US entered recession in December 2007, but unemployment didn’t breach 6% until the end of 2008 and didn’t hit 8% until the economy started to show signs of improvement. Furthermore, the unemployment rate didn’t peak until October 2009—four months after the economy exited recession and seven months after the S&P 500 bottomed.

In contrast, the number of Americans seeking unemployment benefits for the first time has more value as a leading indicator for the US economy. One of the first indicators to signal a recession in 2007, a spike in initial jobless claims tends to precede weakness in employment statistics by a few months.

Although initial jobless claims have slowly and steadily declined since mid-2010, this figure has yet to recede to pre-crisis levels more than three years into the recovery—a testament to the anemic nature of this economic rebound.

The effects of Hurricane Sandy will limit the utility of this indicator for at least a few more weeks. Weekly initial jobless claims had hovered in the mid-300,000s in recent months, but spiked to more than 450,000 per week in the immediate aftermath of the storm. Digging into the data from the Dept of Labor reveals that the majority of this upsurge in first-time unemployment claims originated in New York and New Jersey, the two states that were hit the hardest by the hurricane.

3. Manufacturers’ New Orders, Consumer Goods, and Materials (Index Weight: 0.0811)
This data series tracks new orders for goods destined for sale to consumers and serves as a leading indicator of manufacturing activity and trends in consumer spending.

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4. ISM Index of New Orders (Index Weight: 0.1651)
The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for manufacturing reflects survey responses from managers that make purchasing decisions in 18 manufacturing industries. These questions focus on five key areas of business activity: new orders, supply deliveries, employment, inventories, and production.

Based these responses, the ISM generates a monthly composite index. Values greater than 50 indicate an expansion in economic activity, and readings less than 50 suggest a contraction.

An uptick in new orders tends to presage an increase in industrial production, though manufacturers may need time to purchase raw materials or adjust their workforce to meet demand. Although growing inventories reflect strong industrial production, manufacturers will slash activity if demand in its end-markets begins to wane.

We expect the manufacturing sector’s recent renaissance to continue in coming years, fueled by lower input costs related to rising domestic production of oil, natural gas and natural gas liquids. Domestic manufacturers have also benefited from stagnant US wages at a time when economic growth in emerging markets such as India and China has pushed up labor costs. For these reasons, the manufacturing sector will likely become more important to the domestic economy.

5. Manufacturers’ New Orders, Nondefense Capital Goods Excluding Aircraft Orders (Index Weight: 0.0356)
Capital goods have a useful life of at least three years, and comprise equipment, machines, and tools that companies use to manufacture other items for sale.
 
Spending on capital goods serves as a leading indicator or business investment. If a manufacturer purchases an expensive piece of equipment, the management team must be reasonably confident that existing demand trends will prove sustainable.
 
Investments in defense and aerospace goods can distort monthly data, prompting the Conference Board to exclude these big-ticket items in order to ensure an accurate measure of private-sector demand.

In recent months, orders for capital goods have slumped. Although companies tend to postpone these investments around presidential elections, anecdotal evidence suggests that the uncertainty created by the looming fiscal cliff has exacerbated this normal slowdown. If the president and Congressional leaders eke out a compromise that avoids the worst of the impending tax hikes and budget cuts, investment in capital goods should rebound.

We will monitor this LEI component closely in early 2013 for more clues as to the pace and sustainability of economic growth.

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6. Building Permits, New Private Housing Units (Index Weight: 0.0272)
Homebuilders and contractors looking to erect new homes must request the appropriate permits before starting the project.

New construction not only contributes to the employment rate—and, therefore, consumer spending—but the price appreciation that occurs in a buoyant housing market also makes homeowners feel wealthier.

Although the US housing market has weighed heavily on LEI and the US economy since 2006, the recent recovery in building permits has become a welcome tailwind.

7. Stock Prices, 500 Common Stocks (Index Weight: 0.0381)
Trends in the stock market tend to lead the economy by several months because investors try to anticipate future economic conditions. For example, the S&P 500 peaked in October 2007—about two months before the recession began—and bottomed roughly three months before Great Recession officially ended.

8. Leading Credit Index (Index Weight 0.0794)
A relatively new addition to LEI, the Leading Credit Index reflects the extent to which conditions in the credit and financial markets can influence the real economy.
 
Although many analysts forecast a US recession in 2008, the consensus outlook called for a mild downturn—not the worst economic contraction since the Great Depression. When Lehman Brothers declared bankruptcy on September 15, 2008, banks stopped lending and liquidity dried up. Without access to credit, the global economy ground to a halt.

The Conference Board’s Leading Credit Index is a proprietary indicator that factors in a number of data points that measure the relative health of the credit market.

These underlying data series include a number of indicators that gained prominence during the financial crisis, from data in the Federal Reserve Board’s Senior Loan Officer Survey to the spread between the London Interbank Offered Rate (the rate banks charge one another for short-term loans) and the yield on three-month US Treasury notes. Margin balances, a measure of investors’ willingness and ability to borrow against their stock holdings, also factor into the equation.

By all accounts, credit markets remain healthy and awash with liquidity.

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9. Interest Rate Spread, Ten-Year Treasury Bonds Less Federal Funds (Index Weight: 0.1069)
This LEI component measures the slope of the yield curve, or the difference between long- and short-term interest rates, and reflects the Federal Reserve’s monetary policy.

When short-term rates are much lower than long-term rates, the Federal Reserve has slashed interest rates to stimulate economic growth—a bullish move for the stock market. However, if the yield curve inverts, the central banks has hiked short-term interest rates to slow economic growth.

An inverted yield curve in 2006 and 2007 provided the first signal that the risk of a recession had increased, while the curve steepened dramatically as the economy recovered in 2009 and 2010.

Although the yield curve has flattened since 2010, this development doesn’t necessarily pose a threat to near-term economic growth; the central bank remains committed to an accommodative monetary policy but cannot cut rates further with the Federal Funds rate already hovering near 0%. Instead, the Federal Reserve has relied on quantitative easing—buying financial assets from banks and other financial institutions—to lower interest rates and inject more money into the system.

10. Average Consumer Expectations for Business Conditions (Index Weight: 0.1551)
The Conference Board’s proprietary measure of consumer sentiment, this LEI component tracks similar trends as the Thomson Reuters/University of Michigan Surveys of Consumers. Consumers account for about two-thirds of US gross domestic product; their confidence and outlook for the economy are critical leading indicators.

By the time that the Conference Board releases the LEI, the market already has access to or can readily infer the contribution of many of the individual components that contribute to the comment index. For example, we usually know how the S&P 500 performed in the prior month, and have already received data on the average workweek and initial applications for unemployment insurance.

Whereas these sub-indexes provide insight into the pockets of relative strength and weakness in the economy, LEI has a solid track record of reliably predicting imminent recessions. More specifically, three consecutive month-over-month declines in the composite index portend a US recession.

Fortunately, LEI has yet to post a negative sequential change in 2012, though the index value did decline on a month-over-month basis on three occasions. Only persistent weakness in LEI presages a recession.

We prefer LEI to the Economic Cycle Research Institute’s Weekly Leading Index, as the latter’s focus on higher-frequency economic data can entail significant volatility and yield more false signals. Calling a recession too early or incorrectly predicting an economic downturn can prove costly.

The Verdict
We expect the US economy to continue to grow by 2% to 3% annually, in line with the halting recovery that’s been under way since mid-2009. Although an improving housing market has provided a welcome tailwind to the economy, the likelihood of higher taxes and at least modest cuts to government spending will likely ensure that the US economy obeys the speed limit of recent years.

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