Leading Economic Indicators

By: Mike Shedlock | Tue, Jan 16, 2007
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The Conference Board publishes various lists of Business Cycle Indicators. Those indicators are categorized as leading, coincident, or lagging. This post will take a look at indicators 6 through 10 on the list of leading economic indicators. Indicators 1 through 5 will be covered in a second post at a later date.

Leading Indicators

  1. Average weekly hours, manufacturing
  2. Average weekly initial claims for unemployment insurance
  3. Manufacturers' new orders, consumer goods and materials
  4. Vendor performance, slower deliveries diffusion index
  5. Manufacturers' new orders, nondefense capital goods
  6. Building permits, new private housing units
  7. Stock prices, 500 common stocks
  8. Money supply, M2
  9. Interest rate spread, 10-year Treasury bonds less federal funds
  10. Index of consumer expectations

S&P 500

Looking at the above chart I find it hard to believe that anyone thinks the stock market is a valid indicator of anything.

Starting in 1960 and using a decline of 10% as some sort of leading indicator would have generated five false positives, one miss, and one success. At the start of the 1980 recession the S&P was up year over year about 5%, at the start of the 1982 double dip recession the S&P was up close to 30%, at the start of the 1991 recession the S&P was up over 10%, and at the start of the 2001 recession the S&P was nearly flat. The S&P did not decline 10% before during or after the 1960 recession. As a coincident indicator the results would have picked up 1982 and 1991 but would still have missed 1960 and 1980. In 1987 and 2003 the stock market declined nearly 20% but there was no recession.

Just for fun let's take a look at the Dow Jones Home Construction Index

Did the above chart "lead anything" or did the index peak a month or so after the June 13th 2005 Time Magazine Home $weet Home cover?

Time and time again I hear "The stock market acts six months in advance" Six months in advance of what? I fail to see how it is acting six months in advance of anything. If one is looking for leading economic indicators, the stock market is surely not one of them.

Also note that if one wants a stock market indicator the economy is surely not it. Look at the plunging GDP in comparison to the stock market for recent proof. Look at the homebuilder chart above for recent proof. Look at the historic S&P 500 chart for proof. Seriously, the S&P is a hopeless leading economic indicator and the economy is an equally hopeless stock market indicator.

Yet the myth (and the weighting) that the stock market is a leading indicator still persists. It's no wonder that nearly everyone is confused given that nearly everyone is looking for correlations that simply do not exist.

Consumer Sentiment

This chart of the University of Michigan Consumer Sentiment Index seems to have some merit as a coincident indicator but little as a leading indicator, at least in the timeframe for which this data is available. The indicator also suffers from what seems to be a high percentage of false positives per correct call. As a coincident indicator it has 3 false positive and 4 successes. One could draw the trigger line differently to avoid the false positives but then the big recession in 1982 would be missed entirely.

Housing Permits

Seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation). Currently the chart shows that building permits in November dropped 31% from the year earlier level.

In all seven recessions since 1959 building permits declined year over year. Using the 0% line as a threshold would have picked up the recession in 2001 but would have also resulted in false signals in 1965, 1985, 1987, and 1996 as well. This can be summarized as seven out of seven with four false positives.

Using 20% as the threshold the only false signal was 1987 but there would have also been a missed signal in 2001. This can be summarized as six out of seven with one false positive and one miss.

This is actually a reasonably good performance, especially if one uses a cross of the 0% line as a strong warning signal while waiting for continued confirmation. Note that dips below the 0% line tend to occur well before the onset of recessions. Leading indicators are supposed to lead and this one does. A crossover of 0% is a strong warning and a continuation below the zero line shows that a recession is likely.

Money Supply

In Money Supply and Recessions I introduced M' (M Prime) as a leading indicator based on sound Austrian principles and definitions of money. Those who have not seen how or why I came up with M' can click on the above link to see just what M' is all about. What follows now is a recap of M' vs. M2 as a leading indicator.

M Prime

Leaving the current status as unknown, 6 of the last 6 recessions were marked by a major dip in M Prime. Note how the indicator clearly led the recession. Also note that 6 of 8 sustained dips below an annual growth rate of 5% in M' led to a recession. On that basis we have 2 potential false signals (1985 and 1995).


Unlike M', the direction of M2 does not seem to give clear economic signals. Note that M2 was rising into the double dip recession of 1982 and rising into the 1991 recession as well. Also note that the single largest dip in M2 was in 1993 while M' was soaring. The years between 1992 and 1995 are all problematic. Finally note that unlike M' where a dip below 5% annual growth was a huge warning sign, the dotted line above shows no such significance. M' seems to be far superior to M2 as a leading indicator.

M Prime CPI Adjusted

On a CPI adjusted basis we see that there has been a recession on 6 of 7 sustained dips below the zero line of year over year growth in M'. The 1985 excursion below 0% was extremely brief in stark contrast to all of the labeled recessions and thus can be discounted. 1995 is still a miss but nowhere near as pronounced as compared to M' unadjusted. 1995 also happens to correspond to the start of a huge ramp-up in sweeps. Perhaps that is significant and perhaps not. Nonetheless, M' CPI adjusted gives a cleaner signal, arguably calling for 7 recessions of which 6 happened.

The above chart clearly shows M' CPI adjusted to be a strong leading economic indicator.

M2 CPI Adjusted

M2 CPI adjusted is certainly an improvement over M2 CPI unadjusted. Note however, that the 1982 and 2001 signals are not as strong as the corresponding M' CPI adjusted signals. The M2 adjusted signal for 2001 was particularly weak. More problematic for M2 adjusted vs. M' adjusted is the mass of jello between 1988 and 1996. M' adjusted was clearly giving an "all clear" zero cross signal by 1992 while M2 adjusted gyrated for years and did not really give an "all clear" until 1998. Furthermore M2 adjusted actually dipped back below the zero line in 1997 while M' adjusted was soaring upward. Both M2 and M' missed around the 1996 timeframe but even here M2 did worse both in terms of an actual low and the jello that preceded it.

10yr Treasury minus FF Rate Spread

A dip below zero preceded 6 of 6 recessions since 1965. Unfortunately it generated 5 false positives as well. Of course one can set the line at -1 in which there were only 3 false positive. Or one can set the line at -2 in which case there was 1 false positive and 1 miss. Still, it would be much nicer if we did not have such curve fitting. Can we do better than this indicator?

The Yield Curve

The above chart was generated by subtracting the symbol $IRX from $TNX where $IRX is a 13 week discount and the latter a 10 year yield. Ideally both would be yields but the difference is not that great on the the 13 week. We we use free data when available, and that data not only works well it also happens to be free.

This chart is almost perfect. A three month to 10 year inversion is 6 for 6 with one false positive in 1966. The current situation is considered unknown.

Note how the above chart does not confirm the false signal on the 0% line cross in 1995 of the previously shown real (CPI adjusted) M' chart. Unfortunately the false signal in 1967 on this chart predates the beginning of our M' series of charts, but I suspect there was non-conformation in the other direction, with M' not confirming the this chart.

Comments From Paul Kasriel

Final Thoughts

This post is an attempt to find a methodology that makes theoretical sense and works well in practice too. Five of the ten widely used leading indicators were reviewed, one of which should be discarded outright, one redefined as a coincident indicator, one (housing permits) is valid as it stands, and two leading indicator components had substitutes that seem to work far better in both theory and practice.

The charts show that M' and the 10yr minus the 3 month spread are both superior to similar indicators that are on the list. As time permits, I will take a look at the remaining 5 widely used leading indicators. Thanks once again to Bart at NowAndFutures for providing many charts based on specifications that I requested, and also to Paul Kasriel at the Northern Trust for his time and comments.



Mike Shedlock

Author: Mike Shedlock

Mike Shedlock / Mish
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Mike Shedlock

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

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