Leading, Lagging & Coincident Indicators

October 18, 2011

Over the past few weeks, the stock markets throughout the world rebounded as investors breathed a sigh of relief that European leaders have started to put their house in order. Investors were greatly encouraged by economic data coming out from the U.S. which show that the U.S. economy was in better shape that expected. For example, the most recent weekly jobless numbers declined by 37,000 to 391,000. Retails & car sales were up nearly 10% in September. U.S. ISM numbers stayed above the critical 50 level. How does one make sense of these positive economic data when compared with negative forecasts by renowned economic forecasting organization, ECRI or well-known economist, Nouriel Roubini?

Confusion examined

To be frank, many investors- including yours truly- were flummoxed by these conflicting data or forecast. Thanks to John Hussman, all have been cleared up. In his recent article entitled ‘Europe: Just Getting Warmed Up’, Hussman explained our confusion over the use of Leading, Lagging & Coincident Indicators. To wit:

From my perspective, Wall Street's "relief" about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI's own (and historically reliable) set of indicators, "We've entered a vicious cycle, and it's too late: a recession can't be averted." Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.

The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a "denial" phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession ), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high.

Indicators Defined

The good folks at Investopedia give us a good definition of these three indicators. A leading indicator ‘signals future event’, while a lagging indictor ‘follows an event’ and finally a coincident indicator ‘occurs at approximately the same time as the conditions it signifies’. Investopedia used a traffic light to illustrate how these indicators work. The amber traffic light is a leading indicator of the coming of the red light. It is also a lagging indicator for the green light because amber trails green. Finally, the green light would be a coincidental indicator of the associated pedestrian walk signal. For more, go here.

Understanding ECRI numbers

In another article in July entitled ‘Betting on a Bubble, Bracing for a Fall’, Hussman further explained what to look out for when one uses indicators published by ECRI as well as how one should adapt these indicators to make a call on the stock market, which is itself a leading indicator for the economy. To wit:

The ECRI emphasizes that when interpreting economic data, there are three requirements that have to be satisfied to confidently indicate an oncoming recession - the downturn must be profound, pervasive, and persistent. Profound means a deep decline, which we're clearly observing here. Pervasive means that it must not be driven by simply one or two components (for example, the drop in 1987 was almost exclusively driven by stock prices). ECRI considers a range of factors such as stock prices, housing, employment, money, and confidence measures, among others, but does not articulate the specifics. For our part, we observe not only stock price weakness, but disappointingly high new claims for unemployment, weakening confidence, soft retail sales, easing growth in new factory orders, a flattening yield curve, wider credit spreads, and so forth. This downturn is not limited to stock prices.

Finally, persistence is required. The signal can't last simply for a few weeks. It is here where we require a bit more subtlety than does the ECRI. The reason is that our primary object of interest is the stock market, which is itself a leading - though imperfect - indicator of the economy. The stakeholders of the ECRI are largely interested in economic activity, and can weather a longer period of uncertainty than investors can. I've noted, for example, that the ECRI's admirable recession calls over the past decade have sometimes come only after significant market declines. The March 2001 call, for example, caught the precise beginning of the recession from the standpoint of official recession dating, but the S&P 500 was already down over 25% by that time. This is not at all a criticism of the ECRI, which is an outstanding institution - just an observation that our constituency is different, and timing lags can be very costly.

Conclusion

With this article, I hope the readers would able to put into perspective the many economic data or reports that are announced on the daily basis in the media. Before I go, I shall leave you with this question. Which is more important- the current quarterly results announcements on Wall Street or a survey of Chief Financial Officer’s profit outlook which concludes that profit has peaked (like this one)? The answer should be the latter.

(This is my latest article in Merdeka Review. For the Chinese version, go here)