Leading Economic Indicator

A Leading Economic Indicator is a measurable piece of economic data that changes before the broader economy begins to follow a particular pattern or trend. Think of it as an early warning system for the economy's future direction. These indicators are invaluable for economists, governments, and, of course, savvy investors trying to anticipate the peaks and troughs of the business cycle. While no single indicator is a perfect crystal ball, a consistent trend across several leading indicators can provide a strong signal about whether economic growth is likely to accelerate or if a recession is lurking around the corner. They stand in contrast to coincident indicators (like Gross Domestic Product (GDP)), which move in real-time with the economy, and lagging indicators (like the unemployment rate), which only change after the economy has already shifted. It’s like weather forecasting: seeing dark clouds gather is a leading indicator of a coming storm.

At first glance, leading indicators might seem like tools for market timers—something a true value investor typically scorns. After all, value investing is about buying wonderful companies at fair prices and holding them for the long term, regardless of the market's short-term mood swings. However, ignoring the economic climate entirely would be like sailing without checking the weather forecast. Understanding leading indicators provides crucial context. A series of negative signals can warn of an impending economic downturn. For a value investor, this isn't a signal to panic and sell. Instead, it can be a signal to prepare a shopping list. Widespread fear during a recession often pushes the stock prices of excellent, fundamentally sound companies far below their intrinsic value, creating magnificent buying opportunities. Conversely, when leading indicators are universally euphoric, it might suggest the market is overheated, and bargains are scarce. It helps you assess risk, understand the cyclical pressures on your portfolio companies, and maintain the emotional discipline to act when others are fearful.

Rather than getting lost in dozens of individual data points, many professionals turn to a composite index that bundles the most reliable indicators into one. The most respected of these is the Leading Economic Index (LEI) for the U.S., published monthly by the Conference Board, a non-profit business research organization. The LEI combines ten distinct leading indicators to smooth out the noise and provide a more robust forecast of future economic activity. When the LEI shows a sustained decline over several months, it has historically been a reliable predictor of a recession.

The LEI is a blend of data from across the economy. While you don't need to track all ten components yourself, understanding a few key ones can give you a better feel for the economic winds.

• Average Weekly Hours, Manufacturing: Before laying off workers, factories will first reduce overtime and then cut regular hours. A consistent drop in the average workweek is a strong signal that businesses are seeing less demand.
• Manufacturers' New Orders, Consumer Goods and Materials: This is a direct measure of demand. When companies see a drop in new orders, they anticipate slower production and sales in the near future.
• S&P 500 Index of Stock Prices: The stock market is famously forward-looking. Investors price stocks based on their expectations of future earnings and economic health. A sustained market decline often precedes an economic one.
• Building Permits, New Private Housing Units: The housing market has a massive ripple effect on the economy. A decline in applications for building permits signals a future slowdown in construction jobs, material sales, and home-furnishing purchases.
• Interest Rate Spread (10-year Treasury vs. Federal Funds Rate): This is a proxy for the yield curve. When the spread narrows or inverts (short-term rates become higher than long-term rates), it often suggests that investors anticipate an economic slowdown and lower inflation, a classic recessionary signal.
• Index of Consumer Expectations: Sourced from the University of Michigan's Surveys of Consumers, this measures how optimistic households are about their own financial future and the economy at large. Worried consumers save more and spend less, which can become a self-fulfilling prophecy for the economy.

Leading economic indicators are powerful, but they are not infallible. Any single indicator can give a false signal—a “head-fake”—prompting unnecessary worry or excitement. The real insight comes from observing the trend across a composite index like the LEI or a basket of several indicators over a period of three to six months or more. A one-month dip can be statistical noise; a six-month decline is a serious warning that deserves your attention. For the value investor, the lesson is clear: use these indicators as a tool for situational awareness, not a trigger for rapid trading. They help you understand the broad economic landscape in which you are investing. They can help you prepare mentally and financially for the opportunities that market turmoil can bring, reinforcing the ultimate goal of buying great businesses at sensible prices, come rain or shine.