Understanding Economic Indicators

Economic indicators are confusing. On the same day, some of them are positive and show a growing economy while others are negative and reflect a declining economy. How can anyone know where the economy is headed?

The key to understanding economic indicators is whether the indicator is leading, coincident, or lagging.

All Indicators are Not Created Equal

Economic indicators are like driving in your car. Leading indicators are like looking through the front windshield to see where you’re going, Coincident indicators are like looking out the side mirror to show you where you are, and Lagging indicators are like looking in the rearview mirror to see where you have been. The problem comes when you look at all three images and don’t know which is forward, sideways, or backwards. Trying to drive with the views garbled would be difficult indeed.

As investors, leading indicators are the most important to us because the stock market is also a leading indicator. We want to find the earliest leading indicators that we can and notice the co-incident indicators to confirm what the leading indicators are telling us. That will help us invest at the right time – when stocks are going up or about to go up. Stock prices follow corporate profits, so we want to find economic indicators that rise before corporate profits.

Leading indicators include Hourly Earnings, Consumer Spending, and the Consumer Price Index or CPI.

Average Hourly Wages show the wages that employees earn. Many employees will spend all they make, so as this number goes up there is more money being spent and the economy grows.

Consumer Spending, known officially as Personal Consumption Expenditures or PCE, is similar to hourly wages. As consumers spend more, the economy improves soon after. Corporate profits tend to follow average hourly wages and consumer spending up and down.

The Consumer Price Index or CPI is a broad measure of inflation. It breaks down inflation into many different categories that give a solid understanding of where inflation is coming from – if it is across the board or just a temporary reading in one sector.

This leading indicator is a huge danger signal to warn against coming bear markets. When inflation gets too high, the Federal Reserve raises interest rates. All companies with debt are forced to pay higher rates, cutting directly into profits, not to mention consumers. When the Fed continues to raise rates, a bear market is sure to follow.

The best coincident indicator to watch is the GDP or Gross Domestic Product of the most recent quarter. That is the ultimate indication of how well an economy has done without showing where it is heading. Seeing the trend of GDP gives some indication to help in our analysis of the economy.

The most important Lagging Indicator is Unemployment – it is important to ignore. The Unemployment rate is one of the most commonly reported indicators on the evening news. Most people look at it (especially if they are among the unemployed) and think that is where the economy is headed, but that is incorrect. The truth is that companies hire after their financial situations improve, but by then stock prices have already climbed to reflect this rise in profits. In August 2010, the stock market has been in a bull market for 18 months while the national unemployment rate has not improved much over the same period. This shows unemployment is a lagging indicator.

Keep an eye on the Leading Indicators to drive the vehicle of your investments and you will improve where you want to go.

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Many Profitable Returns,

Gregg Killpack