Tracking the entire economy is overwhelming.
Referring to a limited number of reports can help simplify stock selection.
These general guidelines can help you better predict trends.
In today’s nonstop world, the level of prosperity and our standard of living is greatly impacted by whether the economy is growing, contracting, or just chugging along. Clearly it would seem useful to have an idea of the current and potential future state of the U.S. economy. But in this endeavor, investors face several obstacles. For one, the enormous number of economic reports along with an endless flow of data make the idea of even trying to sort through it all overwhelming. Most people don’t have enough expertise to interpret the data, and even trained economists sort through massive amounts of data and still often draw the wrong conclusions.
So, is trying to discern economic trends a lost cause? Not at all. As with many seemingly large and daunting tasks, the “less is more” approach can be helpful. While the discussion that follows by no means represents a definitive method for evaluating economic trends, it does offer a guide to five key economic indicators and how to interpret them.
1. Leading Economic Index (LEI)
The Conference Board Leading Economic Index offers a broad measure of economic activity as it includes a wide array of measurements. Overall this index does a good job of highlighting changes in the trend of the overall economy. But like any measure, it’s not perfect. The greatest weakness in using this index is that there will be occasional temporary downturns in the index that are NOT followed by a subsequent recession. So, in that sense, it can give an occasional “false warning”. On the plus side, historically if the LEI is rising, the risk of an imminent recession is typically low.
What to look for: A good rule-of-thumb is to be on alert if the LEI turns down, and to become more concerned the longer the index trends lower, and to relax when the index is trending higher.
2. Producer Price Index (PPI)
The Producer Price Index is one of the most commonly used measure of price inflation as it is designed to measure the average change in the sale prices for the entire domestic market of raw goods and services. This measure can give important clues about the health of the overall economy. Prices tend to rise over time, so a certain level of price inflation is normal. However, if inflation rises – or falls – at a high rate of speed, it can cause significant problems for the overall economy. If inflation soars higher it means that prices are increasing rapidly. Therefore, companies may ultimately have to either:
a) Raise the price for their goods and services, which reduces consumers buying power, or
b) Settle for lower profits, which may reduce the value of their business and/or stock.
On the other hand, a period of declining prices – a situation referred to as “deflation” – can actually be worse. During a serious deflation, as prices decline consumers put off buying decisions in hopes of buying at a lower price. As demand declines, prices may decline more leading to more delayed purchases and so on. This can result in a downward spiral. This situation arose most notably in the U.S. in the 1930’s and was a major contributor to the Great Depression.
What to look for: If the PPI is trending gently higher to sideways, this measure is typically not signaling any kind of alarm. When the PPI “spikes” higher or lower, investors should take note of this as a cautionary sign.
3. ISM Purchasing Managers’ Index (PMI)
The ISM Purchasing Managers' Index is designed to measure the economic health for the manufacturing and service sectors in the U.S. economy. This index essentially presents the results of a survey of senior executives at over 400 companies.
The executives are surveyed regarding production, employment, supplier deliveries, inventory levels, and new orders. The purpose of the survey is to determine if business conditions are improving, deteriorating, or relatively unchanged.
The PMI value can theoretically range from 0 to 100. Basic interpretation is straightforward: a PMI value above 50 represents an expansion when compared to the previous month while a value under 50 represents a contraction.
What to look for: If the PMI drops below 50 or drops precipitously for several months, a potential warning sign arises. Otherwise, the implication is generally favorable for the economy.
4. Existing-Home Sales
This monthly report from the National Association of Realtors totals the number of previously constructed homes with a closed sale during the previous month. While new home sales also give information about the state of the economy, existing-home sales make up a larger share of the market than new-home sales and are generally a better indicator of housing market trends.
Existing home sales are an important economic indicator because homes are very often a large part of individual and family wealth. As a result, this report represents a good measure of economic health among the public. If homeowners are having trouble selling their homes and accessing that wealth, it can take some steam out of the economy as a whole.
It should be noted that this tends to be something of a lagging indicator – i.e., it tends to signal a change in economic trend that is already in place.
What to look for: In general a decline over the previous 12 months should be considered a warning sign. The sharper and more persistent the 12-month decline, the more significant the warning.
5. Nonfarm Payrolls
The more people that have jobs, typically the healthier the economy. The U.S. Bureau of Labor Statistics releases a monthly report on nonfarm payrolls as part of its Employment Situation Report. The figure reported represents the change compared to the previous month and is viewed as a gauge of economic health.
The Non-Farm Payrolls figure excludes those employed by private households, nonprofit organizations and the military as well as those involved in unincorporated self-employment or farm work. In a sense it measures the number of people who have been hired by someone else to perform a specific for-profit job function. This group accounts for roughly 80% of the workers who produce the entire GDP of the United States.
What to look for: While there are various ways to interpret any data series, a simple approach to nonfarm payrolls may be the most effective. A declining trend is considered a warning sign and a rising trend is considered positive.
There are many other economic reports that one can look at and analyze. But for the average investor, simply keeping track of the current status and/or trend of the five reports we have discussed can allow them to get a reasonably accurate sense for the current overall status of the economy.
If none or perhaps only one of the potential warning signs we discussed are showing, then an investor should not spend much time worrying about the economy regardless of the noise in the financial press. But as more warning signs emerge and persist, the more cautious an investor should become regarding the broader trend in the U.S. economy.
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