LIZ ANN SONDERS: Investors often focus on traditional measures for the economy, like gross domestic product, GDP, as a sign of how the economy is doing, but it’s important to remember that that’s a very lagging economic indicator. It tells you what has already happened in the economy, which is why economist market watchers spend more time focusing on the leading indicators. I certainly do that, and the index that I track most closely, as do most economists, is the Leading Economic Index put out by the conference board. It’s a monthly look at about 10 subcomponents--all of which tend to lead changes in the economy--so I call them the "heads-up" indicators.
Now, they were created largely to just pick up major turning points in the economy, so the creation of this index was there to give you a heads-up when we’ve seen elevated risk of a recession--starting a recession. It also tends to give you a heads-up when you’re coming out of a recession, so it tends to lead these inflection points.
But I get a lot of questions about whether the Leading Economic Index is a good forecaster of what the economy is going to do, so we crunched a lot of the numbers, and I’ve got two charts that are interesting. The first looks at whether or not the leading indicators have been a good forecaster of what the economy does, say a year from now. And what you’re looking at is a correlation chart, so it’s a scattergram. It compares change in the Leading Economic Index to subsequent one-year change in GDP, and you can see, based on the trendline, that it’s a very high correlation. A reminder for those not familiar with correlation, that 1.0 is a perfect correlation, one-for-one relationships.
Well, some then infer--well, if the stock market is one of the leading indicators (which it is) let’s take a look at the change in the leading indicators and see if it’s similarly correlated to what the stock market does a year from now. And here’s where it gets a little interesting, because you actually dip to a negative .10 correlation between changes in the Leading Economic Index and the S&P 500 return, over the subsequent year.
What I really think the most important thing that that points out is that, although the stock market is one of the leading indicators, it’s probably the most leading of the leading indicators, so its move tends to come in advance, which--by the time you’ve seen the overall change to the leading indicators--you may have already seen the bulk of the move in the market, which is why that correlation has dipped to negative. These are very important relationships to understand as an investor, between leading, lagging and coincident indicators.