The economy affects us all, from the availability of jobs to how much bread and milk cost. Economic indicators help us assess how the economy is doing right now, how it could be doing in the future, as well as how it has done in the past. By understanding how economic indicators work you can monitor them yourself when they are released, forming your own opinion about the markets and the economy, as well as spot errors in others analysis, such as using a lagging indicator to predict the stock market.
Economic Indicators 101
The economy goes through four broad cycles: expansion, peak, contraction and trough. During the expansion and peak there are lots of jobs and most people are happy with how things are going. During the contraction and trough phases things get tougher, but the bright side is that the whole cycle then starts again.
Be sure to read A Trader’s Guide to Understanding Business Cycles
Where we are in the economic cycle affects everyone; it affects how much food costs, how much money is floating around and even your job security. This is why economic indicators matter, because they tell us where in the cycle we are, in which direction we are moving, and when we may (or are) entering the next phase.
This is accomplished through three types of economic indicators: leading, lagging and coincident, each discussed below.
Most analysts and traders don’t focus on the specific number from an economic indicator, but rather look for trends in the data over several releases. They watch for overall rises and falls, for example in Unemployment, to determine the health of the work force and economy.
Economic indicator data is released at recurring scheduled times, and can be viewed on an Economic Calendar, like this one available from Bloomberg.
Leading Economic Indicators
Leading economic indicators help us assess where the economy is headed. They foreshadow what is coming, such as moving from a peak phase into a contraction, before it actually happens.
One of the most significant leading indicators is the stock market itself, gauged by an index such as the S&P 500. It will begin to rise before economic conditions seems favorable, and it will be begin to decline before economic conditions seem to warrant it.
Building Permits are a leading economic indicator, since an increase in Building Permits also typically entails an increase in workforce and robust demand for houses. Houses cost money, and money isn’t available during dire times.
It is possible that Building Permits can increase, but there isn’t enough demand to buy all the homes. When this occurs housing prices are typically pushed down and will have a dampening effect on the whole economy.
Figures 1 and 2 below show Building Permits and the S&P 500. Building Permits were already starting to rise at the start of 2009, while the S&P 500 started to rise a couple months after. Remember though, Building Permits are a not a leading indicator of the stock market, they are a leading indicator for the economy. This is why both Building Permits and the S&P 500 turned higher while many analysts still thought the world was ending, and continued to trend higher as conditions improved.
All charts provided by TradingEconomics.com
Another important leading indicator is interest rates. Low interests stimulate borrowing and buying, which favors the economy. An increase in interest rates shows the economy is doing well, but eventually rising interest rates lead to a slow down because less people borrow money to start new projects.
Interest rates can also be considered a lagging indicator, since interest rate adjustments come after economic forces demand them. Since interest rates tend to trend for long periods of time, changes potentially have a predictive quality.
Leading indicators help assess the outlook for the economy, but analysis of them is subjective. Building permits, and other leading indicators, such as the S&P 500, don’t move in a straight line. This means the outlook isn’t always clear, and is subject to interpretation.
Lagging Economic Indicators
Lagging economic indicators reveal past information about the economy, or the data takes so long to compile and release that it doesn’t reflect what is happening now, just what was happening months ago.
Gross Domestic Product (GDP) is how much a country is producing. It is released on a quarterly basis and data is released initially a month after the end of the quarter, and then revised another two months after that. There is significant lag time between when the data is compiled and when it is released, yet is a still an important indicator. Many consider a recession to be underway if two quarters see back-to-back declining GDP.
Instead of looking at the actual GDP number, many analysts and traders prefer to look at the percentage growth rate. For established economies this is usually fairly stable, with the economy growing between 2% and 5% as shown in Figure 3 for the U.S.. A drop below this, and especially below 0% growth, shows the economy weakened, while a rise above the range shows strong growth.
Note how GDP did not see positive growth (above 0%) until well into 2009/ 2010, while Building Permits and the S&P 500, which are leading indicators (figures 1 and 2), saw a rise much earlier in 2009.
GDP can be biased by government intervention, such as stimulus packages. Also, like other indicators, it will move up and down, making analysis subjective.
Other indicators, such as the Consumer Price Index (CPI), are also sometimes considered lagging indicators, since they reveal information that is already known to most consumers (they experience price increases or decreases before the CPI tells them prices are going up or down). Since this inflation data is generally released in a timely fashion though, and reflects a recent or current state of affairs, this and other indicators are covered under the Coincident Economic Indicators below.
Coincident Economic Indicators
Coincident economic indicators tell us where we are in the economic cycle, as well as information about the strength or weakness of the economy right now.
Non-farm payroll employees is one of the most followed economic indicators and has a big impact on financial markets because it provides data on the health of the job market (non-agricultural), which affects everything in the economy. Related to this is the unemployment rate. A declining unemployment rate shows demand for employees, and indicates the economy is in good shape. Rising unemployment means people are losing jobs and it will be harder to find work; as you may suspect, this is not good for the economy.
Figure 4 shows the unemployment rate increasing until the start of the 2010. Since unemployment tells us about the current state of the economy, we can see how the other indicators acted in relation to it. Mainly, the leading indicators (Figures 1 and 2) turned higher well before the unemployment rate turned lower.
Producer Price Index (PPI) and Consumer Price Index track price changes at the wholesale and retail level, respectively. The Inflation rate tracks similar data, but in month-over-month percentage terms. Slightly rising prices are a good thing, as it shows money is flowing freely in the economy. Falling prices are generally a poor sign for the economy as there is little demand for goods.
All coincident indicators are best analyzed in terms of overall trend, as fluctuations are common from month to month. Trying to interpret each data release on its own and out of context will likely lead to an improper assessment of current conditions.
The Bottom Line
Economic indicators are a useful but imperfect tool for seeing there the economy has been, where it is, and where it’s going. Economic indicators are subject to interpretation, and conflicting data from one release to the next is common. It is therefore best to look at overall trends in data, as well as assessing all three economic indicator classes: leading, lagging and coincident. By following a couple of indicators in each class, investors are more likely to be able to get a read of overall conditions.
The stock market itself is one of the most powerful leading indicators we have, which means applying economic data to try to predict it is often fruitless; instead, use the stock market to predict where the economic cycle is headed.
To familiarize yourself with economic indicators, scroll through and continually monitor an economic calendar. Events marked in red are typically high impact, and deserve close attention; yellow events have less of an impact, but still deserve attention.