Schwab Guide to Economic Indicators: Leading Economic Indicators (LEI)

by the Schwab Center for Financial Research
April 3, 2008

What is it?
The Leading Economic Indicators (LEI) index is a summary of 10 variables (see “How is it calculated?” below) used to help identify turning points—peaks and troughs—in overall economic activity. It’s produced monthly, along with two other indexes summarizing coincident and lagging indicators, by the Conference Board, a not-for-profit business membership and research organization.

What is its relative importance?
Medium. The reason the LEI’s importance isn’t rated “high” is because most of the results of the 10 variables that comprise the index are generally known prior to the LEI’s release. Yet it’s still a useful report. In describing the LEI and the organization’s other two indexes, the Conference Board explains, “They’re constructed to summarize and reveal common turning-point patterns in economic data in a clearer and more convincing manner than any individual component—primarily because they smooth out some of the volatility of individual components.”

What impact does it have on the market?
A rising index depicts economic strength; a declining index reflects economic weakness.

If the LEI index...

The overall economic backdrop and expectations of what’s needed from monetary policy and where it’s perceived to be headed play a major role with the direction of stock prices.

If the trend in the index exceeds forecasts in a way that hints that the economy is overheating, bond prices could fall (yields rise) on the outlook for greater overall economic demand, potentially higher inflation and an increased chance that the Federal Reserve will hike interest rates. Stock prices may also fall.

Why?

A rise in bond yields can eventually make bonds more attractive once the fall in bond prices settles down. Compared to where the weights of stocks and bonds were in your portfolio, the typical thing to do in response to this change in valuation would be to sell a portion of your stock portfolio and put the proceeds into bonds. Even if corporate profit growth seems supported in this time of strong home sales, the market will likely see it as being short-lived given expectations for impending rate hikes and eventually slower economic growth.

There’s a scenario in which stock prices could experience a temporary lift if the economic backdrop is subdued. Suppose the index comes to life in a manner suggesting the overall economy could be on the verge of rebounding from a weak period. This could give a boost to stock prices even with an expected rise in bond yields, because the market’s expectation of potentially higher profit growth from greater economic demand can initially be the more influential factor in favor of higher stock prices.

That is, for a period of time, it can be the more-dominant driver of stock prices, overshadowing the negative impact of rising bond yields (as discussed above). While renewed strength in the index might suggest an eventual need for Fed rate hikes, it probably wouldn't be deemed immediate because of an otherwise weak economic backdrop. It would likely take some time for other economic reports to strengthen in order to validate the existence of an economic recovery.

A weak index could lift bond prices (and reduce yields) based on expectations of less inflation pressure. Suppose the economy were strong, but monetary policy had recently become tight (restrictive). Stock prices could improve on hopes of a halt in the Fed’s rate-hike campaign, along with the possibility of a future injection of economic stimulus if the next move by the Fed were a rate cut.

A weak index and a weak economy probably wouldn’t help stock prices, because the chance of recession and reduced corporate profits would likely be the dominant fears.

How is it calculated?
The Conference Board assigns weights to each of the following 10 variables (provided by various sources) to calculate the LEI:

Average workweek of production and manufacturing workers (hours)
Initial jobless claims
Manufacturers’ new orders of consumer goods and materials
Vendor performance (an index measuring “slower deliveries”)
Manufacturers’ new orders of nondefense capital goods
Building permits
Stock prices (S&P 500)
Money supply (M2)
Interest rate spread: yield of the 10-year Treasury note less the federal funds rate
Consumer expectations

Every month, the Conference Board evaluates the performance of each component based on known results or estimates. Values are assigned for each and are summarized to produce the LEI index.

A base-year approach is used. That is, the Conference Board converted the LEI’s 1996 outcome to a base figure of 100. All subsequent LEI monthly readings are relative to this base year.

How is it used?
The report is used along with a variety of other economic indicators to help gauge the direction and strength of the economy, and what the Fed might do next with short-term interest rates. Though this monthly indicator is not as comprehensive and meaningful as the quarterly gross domestic product report, its timeliness can be important. This can occur when economic growth is thought to be near a turning point—up or down—by providing a monthly heads-up while quarterly data is awaited.

When is it released?
The report is released near the 20th of the month and can be found at the Conference Board’s home page. Click on “U.S. Leading Index” for the latest report.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(2008-3705)

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