Leading Indicators

Leading indicators are a set of statistics about economic activities that help in macroeconomic forecasts of the economy and emerging stages of business cycles across the industry by acting as a variable with economic linkage. It provides early signs of turning points in business cycles that precede coincident and lagging indicators.

These economic indicators can provide early signs of upturn or downturn in GDP. Investors and government bodies can use these indicators to predict the economy's direction and make importing investing and policy decisions. It thus helps in taking proactive actions to achieve economic and other strategic goals.

1. Leading indicators are a group of data on economic activity that, by serving as a variable with an economic connection, aid in macroeconomic forecasts of the economy and emerging business cycle phases across industries.
2. Leading indicators are useful for understanding whether the economy is in a recession or expansionary phase so that policymakers can make their decisions supporting the same.
3. Stages for identifying leading indicators are mapping the growth cycles and identifying the turning points. Then, these indicators are assessed for efficiency, and OECD guidelines help in further analysis.

Leading indicators are dynamic variables which help in identifying turning points in eLeading indicators are dynamic variables that help identify turning points in economic activities. Prediction of economic trends is possible by tracking such indicators through an appropriate index. However, as they are inaccurate, the actuals may not be equivalent to lead indicators. Lead indicators help in designing macro-economic policies by countercyclical policies to tackle economic cycles of boom and busts.

For macro-economic policy decision-making, it is necessary to know the state of the economic cycle, i.e., whether the economy is in the expansionary phase or whether it is moving towards the recessionary stage so that countercyclical stabilization policies can be implemented. For understanding the same, different data points of a series of economic variables are used, giving information about the economy's state in past, present, and future predictions. These data points are called economic indicators.

Economic indicators are classified into three categories - coincident indicators, leading indicators and lagging indicators. Leading indicators forecast economic activities’ turning points, coincident indicators give a real-time state of economic activities, and lagging indicators reflect the past economic activities..

Leading indicators help economists predict the future trajectory of economic activities by forecasting the direction of GDP and thus help in better macro-economic policy decision-making.

The leading indicators in trading are many, but the most popular ones that help in determining trading strategies are as follows:

Relative Strength Index (RSI)

RSI is an indicator that lets traders identify overselling and overbuying markets. It signals the reverse movement in the trading market. As a result, traders can decide whether to enter a trade or exit. An RSI of more than 70 indicates an overbought market.

Stochastic Oscillator

A stochastic oscillator helps traders to compare the closing price of the current day with the trading range of the previous day. As the market momentum changes faster than the trading volume and price, the stochastic oscillator becomes the best way to identify the proper market status. If its value is 80 or more, it indicates an overbought market, while anything below 20 symbolizes an oversold market.

William %R

Unlike other leading indicators in trading, Williams perfect range works on a negative scale. It is marked from zero to -100. If the value is -20, the market is considered overbought and if it is around -80, the market is oversold.

On-Balance Volume

It is yet another momentum-based indicator, the predictions of which depend on the volume, and this is why traders use OBV in shares trading. In shares trading, the volume is thoroughly specified by stock exchanges. Hence, recording the volume and relying on the details is easier.

Burns and Mitchell first brought out the leading indicator approach post-1930 depression. Economic Cycle Research Institute (ECRI), founded by Dr. Geoffrey Moore, established the first list of 8 indicators viz, commodity prices of sensitive commodities, average workweek of Manufacturing, building contracts, new incorporations of companies, orders released, housing statistics, index of stock prices, liabilities due to business failures.

Later, the US conference board started publishing these indicators. Finally, from 1980, the Organization of Economic Cooperation and Development (OECD) started publishing the CLI (Composite Leading Indicator) index for major countries.

• The first stage of leading indicator identification and indexing is identifying the growth cycles. An adjustment needs to be made for seasonality and short-term irregularities in the growth cycle. The second is to identify turning points determined by Bry and Boschan and the Artis et al. rule.
• Next, turning point indicators are assessed for quality by measuring the efficiency of leads through mean and standard deviation. Further analysis is done to identify indicators as per OECD guidelines, viz, cross-correlation, coherence and mean delay, dynamic factor analysis, common component variable, cyclical classifications. Self-organizing maps can also be used for the selection of lead indicators.
• After selecting lead indicators, an index is developed to analyze and compare the movements. The index is developed through linear and nonlinear frameworks. The linear framework can be created using the diffusion index – measuring the proportion of indicators of economic activities that are experiencing expansion in a given period.

Other methods are the Stock and Watson approach which uses a common trend principle. Autoregressive distributed lag method, which uses GDP as a reference point. Nonlinear frameworks are a Probit model or logistics model where discrete regression analysis is used, Markov – switching autoregressive model is also used.

Let us consider the following leading indicators examples to understand the concept better:

Example 1 - US economy list of indicators

Example 2 - Germany economy list of indicators

Leading indicators help traders take decisions that would prove fruitful for them. The advantages of using them are as follows:

• Help in identifying and predicting future trends and events in the economy. Traders use them for forecasting the overall economic activity.
• Help in identifying and tracking the growth cycles in the economy.
• Help to take corrective measures in advance to counter economic trends.
• Lead indicators help in macroeconomic policy decisions.
• Monetary policy framework can be used as a countercyclical measure by relying on lead indicators
• Lead indicators provide adequate early warnings of cyclical indicators of economic activities.
• Help in getting the overall view of the economy, unlike the lagging indicators, which focus on short-term performance.

Leading indicators also have some flaws. Let us have a look at them too:

• These indicators are difficult to identify.
• Leading indicator measurement is difficult and may not be accurate.
• It involves qualitative factors and accurate quantification of the same may be difficult.
• Validation of lead indicators may be a challenge and they may not match closely with actuals.

This has been a guide to what are Leading Indicators. Here we discuss the examples along with its types, methodology, benefits, and limitations. You can learn more about finance from the following articles –

• Types of Market Indicators
• Unemployment Compensation
• Macro Environment Definition
• Compare - Leading vs Lagging Indicators