What Is a Leading Indicator?

What Is a Leading Indicator?

Let me explain what a leading indicator is—it's a measurable set of economic data that can help you forecast future economic activity. You can use these leading economic indicators to predict changes in the economy before it starts shifting in a particular direction. They're potentially useful for businesses like yours, investors, and policymakers.

Leading indicators are one of three main types of economic indicators. The other two are lagging indicators and coincident indicators.

Key Takeaways

A leading indicator is economic data that may correspond with a future movement or change in the economy. These indicators can help you predict an occurrence or forecast the timing of events and trends in business, markets, and the economy. Different leading indicators vary in their accuracy and leading relationships, so you should consult a range of them when planning for the future. Examples include the Consumer Confidence Index, Purchasing Managers’ Index, initial jobless claims, and average hours worked. In contrast, lagging indicators are metrics that confirm change rather than predict it.

Understanding Leading Indicators

Leading indicators must be measurable to be useful as predictors of where the economy may be headed. Policymakers and central bankers use them when setting fiscal or monetary policy. Businesses study them to anticipate the effect of future economic conditions and then make strategic decisions regarding markets and revenue.

All businesses track their own bottom lines and balance sheets, but such data are lagging indicators, meaning they're produced by events that have already happened. Importantly, a business’s past performance does not necessarily indicate how it will do in the future.

Investors use leading indicators to guide their investment strategies as they try to anticipate market conditions. Many focus on those indicators directly related to the stock market, such as the housing market, retail sales, building permits, business startups, and more.

Examples of Leading Indicators

Let’s look at the Purchasing Managers’ Index—economists closely watch the PMI because it reflects trends in the manufacturing and service sectors and can signal growth in a nation’s gross domestic product due to changes in demand for materials from corporations.

Durable goods orders is a monthly survey of manufacturers produced by the U.S. Census Bureau. It measures industrial activity in the durable goods sector and the state of the supply chain.

Along with durable goods orders, many consider the Consumer Confidence Index to be one of the most accurate leading indicators. This index surveys consumers about their attitudes toward the economy and their perceptions of economic activity going forward.

The U.S. Department of Labor provides a weekly report on jobless claims as an indicator of the economy’s health. A rise in jobless claims indicates a weakening economy, which could negatively affect the stock market, while a drop may indicate companies are growing and hiring, which can be positive for the market.

Many market participants consider the yield curve to be a leading indicator, especially the spread between two-year and 10-year Treasury yields. If two-year yields exceed 10-year yields, creating an inverted yield curve, it may signal that a recession is approaching.

While not a metric issued by economists or government agencies, customer complaints or negative online reviews can be seen as a leading indicator of customer dissatisfaction that may signal problems with a business’s product quality or service failures. These can point to lower future revenue, growth, or profits, whereas positive customer satisfaction data may suggest these factors will trend upward.

Accuracy of Leading Indicators and How to Use Them

Leading indicators often present tradeoffs among accuracy, precision, and lead time in predicting future events. They are not always accurate, but looking at several in conjunction with other types of data may provide actionable information about the future health of an economy.

An ideal leading indicator would predict changes in economic trends or business performance accurately, within a narrow range of estimates, and over a major time horizon. However, in practice, all leading indicators show variable performance along these lines.

For example, the advance warning of economic downturns provided by capital goods new orders data can offer a long lead time for action, but the historical lead time between turning points in capital goods and a specific target like changing stock prices or GDP may range from 12 to 24 months. You end up with data indicating a long lead time but low precision about when to take action.

What’s more, the magnitude of changes in capital goods new orders might not bear any consistent relationship with the size of changes in GDP, making it inaccurate except as an indicator of timing. Therefore, this indicator would be useful as a long-term warning sign, but it would not support a precise estimate of the timing or size of future trends.

On the other hand, a leading indicator might give highly accurate and precise information about a turning point or trend in the market or economy, but only over a few months or quarters. Such an indicator could provide detailed input for estimating trends that affect your business or investments, but it might not provide that information in sufficient time to take full advantage.

By themselves, both types of leading indicators might be helpful, yet neither provides the full picture needed to maximize performance. In practice, this means using a range of different leading indicators that are more or less accurate, precise, and forward-looking can provide the best opportunity to capitalize on future trends.

Leading Indicators vs. Lagging Indicators

Leading indicators are used to predict future economic performance, while lagging indicators are data that reflect past economic performance and are used to confirm economic change and financial market patterns.

What Are Leading and Lagging Indicators?

Leading indicators are measurable pieces or sets of data that may suggest future economic, business, or investment trends. A lagging indicator is a measurable figure or set of data that changes at some point after an economic or business trend occurs.

What Are the 3 Types of Economic Indicators?

Leading indicators are one of the three main types of broader economic indicators. The others are lagging indicators, which reflect past activity, and coincident indicators, which reflect current activity.

Where Can I Find Reports on Leading Indicators?

The reports are issued by various government agencies and other organizations. Certain business publications, like the Wall Street Journal, will publish a calendar of upcoming announcements as well as the actual data. Some of the entities responsible include The Conference Board for the Consumer Confidence Index, the U.S. Department of Labor for jobless claims, and the U.S. Census Bureau for durable goods orders.

What Is an Example of a Leading Indicator?

One of the most famous examples is the Consumer Confidence Index. This is a survey regularly performed by The Conference Board to determine how optimistic or pessimistic consumers are about their expected future financial situation.

The Bottom Line

Leading indicators have the potential to be a highly valuable tool for economists, investors, business owners, and consumers like you. When used properly, they can signal upcoming changes and broad trends in the economy. However, the economy is not guaranteed to behave in the way that leading indicators suggest, and it is crucial that you know which indicators are most appropriate to evaluate and how to properly make use of them.