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What are leading and lagging indicators

what are leading and lagging indicators

Leading And Lagging Indicators Of Stock Market Performance

Feb. 22, 2015 1:24 AM

  • Identifying which economic indicators lead and lag stock market performance is critical in managing investment risk.
  • Consumer spending is a leading indicator, while employment is lagging, but conventional wisdom leads investors to believe otherwise.
  • The downtrend in the annual rate of growth in spending does not support the uptrend in stock market indices.

The stock market (NYSEARCA:SPY ) has long been considered a leading indicator of economic activity, as investors respond in real time to what is happening from day to day. Investors also have the ability to respond in real time to the possibility that either adverse or favorable events may occur. This is commonly thought to strengthen the market's capacity to serve as a discounting mechanism. As such, most investors view recent stock market performance, good or bad, as an indication of how the economy is likely to perform moving forward. This is why investors are more inclined to invest closer to market tops, rather than market bottoms. If the economy is likely to improve, based on the uptrend in stock prices, then that will reinforce and strengthen the fundamentals, which will support even higher stock prices.

Yet the stock market's forecasting ability has been compromised on two fronts. The digital age has dramatically sped up the flow of, and increased access to, information that was previously available only to Wall Street insiders. Information is now a commodity that nearly every investor can access instantaneously. This has led market performance to become more of a coincident indicator of economic activity. Another factor is the Fed's monetary policy intervention in the market, intended to use financial assets as a catalyst to achieve a desired economic outcome. If that outcome does not result, then the stock market will end up being a lagging indicator of economic activity, which would have dire consequences down the road.

There are other economic indicators that lead stock market performance, which long-term investors should be more heavily weighting when making investment decisions. At the same time, investors need to deemphasize those indicators that lag market performance. The first step is to identify what is leading and what is lagging, which is not easy to do, because it often contradicts conventional wisdom. Market pundits and the financial press regularly misconstrue what is leading and what is lagging, because they do not understand the sequence of events that power the business cycle, or the cause and effect relationship between the different economic indicators. This can lead investors to miscalculate the strength of the economy, looking backwards when they should be looking ahead, as they make investment decisions. A prime example is the relationship between employment, a lagging indicator, and consumer spending, which is a leading indicator.

The latest series of employment reports have been nothing shy of outstanding. Weekly claims for unemployment benefits have fallen well below 300,000, and more than one million new jobs have been created just in the past three months, helping to push the unemployment rate down to 5.7%. The stock market has responded with continual new highs in the major market averages. At the same time, despite the drop in gasoline prices, consumer spending data in recent months has been very disappointing. Pundits and the press have dismissed this weakness as temporary, explaining that the improvement in the labor market will lead to increased rates of consumer spending growth. This expectation is based on the assumption that employment leads to consumption, when in actuality, it is the reverse. It is consumer spending that drives job creation, and changes in the rate of consumer spending lead major inflection points in the stock market, whereas changes in the rate of employment growth follow those inflection points.

Consumption is what fuels the engine that is our economy. If we think about the business cycle as a conveyor belt, then it is consumer spending that comes out first, followed by the creation of jobs much farther down the line. As a result, consumer spending is the primary driver of job creation. Consumer spending leads to business activity in both manufacturing and services, which in turn leads to capital spending and corporate profits. Profit growth leads to gains in employment. When slack in the labor pool falls to a certain level, wages begin to rise. It is then the rise in wages that sustains and increases the rate of real consumer spending, and we have come full circle.

I am not suggesting that a newly created job does not lead to additional consumer spending - it does. Yet job creation is not the

primary driver of consumer spending, as most market watchers in the financial press purport it to be. Instead, it is a result of that spending. This is why the labor market is one of the last parts of the economy to show improvement during an economic recovery. It is also the caboose in terms of economic indicators that deteriorate at the end of an expansion.

The stock market's reaction to recent employment and consumer spending reports would lead an intuitive mind to an entirely different conclusion. The stock market yawned in response to the worst back-to-back declines in monthly retails sales figures since October 2009, while upbeat employment reports have been followed by rally after rally.

Still, one or two monthly reports is not a fair read on the health of consumer spending, or any other economic statistic for that matter, considering how often the numbers are revised at a later date. The month-over-month view can also distort the long-term trend. A far better representation of the trend in consumer spending can be seen in the year-over-year rate of change, as depicted below. Considering the strengthening employment data, this trend line is moving in the wrong direction if gains in employment lead to growth in consumer spending, but it does not. This is why consumer spending is far more relevant than employment data for investors looking to gain insight into how the stock market may perform moving forward.

The employment data typically looks its best at the end of an economic cycle and bull market run. It looks its worst well after an economic recovery begins to take hold and the stock market has bottomed. As an example, in the most recent unemployment claims report, it was noted that the number of job seekers for every open position, which is a measurement of how much slack there is in the labor market, hit its lowest level since 2007. That's great news, except that 2007 marked what was close to the end of the last economic cycle and bull market. When unemployment claims were peaking during the Great Recession and the unemployment rate was over 10%, it was the investment opportunity of a lifetime. The bottom line is that employment is a lagging indicator, with little predictive value for either the economy or the stock market.

On the other hand, consumer spending tells us a great deal about where the economy and the stock market are likely headed, but with an extremely long lead time. This is because it is the primary driver of economic activity. As depicted in the chart below, it is not uncommon to see the stock market rise as the year-over-year rate of growth in retail sales declines, but if that growth rate does not reaccelerate, the stock market realigns with the downtrend in sales.

Source: FactSet

Therefore, investors should be placing far more emphasis on consumer spending data, rather than employment statistics, when anticipating stock market performance and the risks associated with it. However, that is clearly not happening. Pundits continue to dismiss weak spending in the wake of better employment figures, assuming that employment is what drives faster rates of consumption. To the contrary, it is an increase in real wages that drives faster rates of growth in consumer spending, but this has been the missing link in this economic expansion. If not realized soon, based on the historical relationship depicted above, the stock market becomes increasingly susceptible to a downward adjustment. I intend to follow this article with a discussion of where other leading indicators stand relative to stock market performance, focusing on incomes.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.

Category: Forex

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