FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Leading Indicators

Updated on April 29, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Are 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.

Leading Indicators Meaning

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.

Key Takeaways

  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 Explained

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 bustsCycles Of Boom And BustsBoom and Bust Cycle is the Gross Domestic Product (GDP) cycle of upward and downward movements along with its long term trend. It helps identify the level of production in the economy and the performance of the associated economic indicators such as employment, inflation, stock performance, and investor behavior.read more.

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 indicatorsLagging IndicatorsLagging indicators are used to identify long-term trends or economic patterns by referencing to a series of economic activities that occurred in the past. They can't predict the future because lagging indicators only shift when major economic events occur.read more 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.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

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

Leading Indicators Types

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.

Methodology

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.

Examples

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

Example 1 – US economy list of indicators

LeadingCoincidentalLagging
Avg. weekly manufacturing hoursEmployees on payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more (excluding agriculture)Average unemployment duration
Avg. weekly unemployment insurance claimsInsurance ClaimsAn insurance claim refers to the demand by the policyholder to the insurance provider for compensating losses incurred due to an event covered by the policy. The company either validates or denies the claim based on their assessment and nature of the incurred losses.read morePersonal income levelsInventory to sales ratio (showing inventory turnover/ buildup)
Manufacturers’ new orders in consumer goodsConsumer GoodsConsumer goods are the products purchased by the buyers for consumption and not for resale. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy.read more and non- defense capital goodsIndustrial productionLabor cost per unit of output
Vendor performanceManufacturing and trading salesAverage prime rate Commercial and industrial loans
Building Permits Stock IndexStock IndexThe stock index, which is also known as the stock market index, is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment investors use it to have knowledge about the performance of investments and access the total value they possess.read more Consumer installment credit to personal income ratio
Money supply and interest rate spread  
Consumer expectation Index  

Leading Indicator

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Leading Indicators (wallstreetmojo.com)

Example 2 – Germany economy list of indicators

LeadingCoincidental
New ordersIndustrial production
The yield spread 10 years compared to 3 monthsManufacturing and retail sales
Changes in inventoriesPersons employed
Gross enterprise and property income 
Stock prices 
Residential constructions 
Services consumer price index- a growth rate 
Consumer Confidence Index 

Benefits

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

Limitations

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.

Frequently Asked Questions (FAQs)

What are leading indicators KPIs?

A measurable component is a leading KPI indicator shift before the business adopts a pattern or trend. Although they are sometimes correct, leading KPIs are used to forecast organizational changes.

What are composite leading indicators?

The Leading Economic Index (LEI), also known as the Composite Index of Leading Indicators, is an index released monthly by The Conference Board. It is employed to forecast the course of upcoming global economic movements.

What is the best leading indicator?

The most helpful leading indications to watch are these five. They are the yield curve, orders for durable goods, the stock market, manufactured products, and permits for new construction.

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 –