What if you could see economic changes coming before they happen? Leading economic indicators aim to do exactly that. These forward-looking metrics tend to change direction before the overall economy, giving traders and investors valuable time to adjust their positions.
What Are Leading Economic Indicators?
Leading indicators are economic metrics that typically change before the economy as a whole changes. They help forecast future economic activity and identify turning points in the business cycle. When leading indicators turn down, it often signals a recession is coming. When they turn up, it suggests recovery is ahead.
Key concept: Leading indicators are not perfectly reliable. They have predicted "nine of the last five recessions" as the famous joke goes. But used together, they provide valuable information about where the economy is headed.
The Conference Board Leading Economic Index
The Conference Board publishes the most widely followed composite of leading indicators, the LEI. It combines 10 components into a single index:
The 10 LEI Components
- Average weekly hours (manufacturing): Employers adjust hours before hiring/firing
- Average weekly initial jobless claims: Rising claims signal weakening labor market
- New orders for consumer goods: Demand precedes production
- ISM new orders index: Manufacturing demand outlook
- New orders for capital goods: Business investment intentions
- Building permits: Housing construction leads the economy
- S&P 500 stock prices: Markets discount future conditions
- Leading Credit Index: Financial conditions and credit availability
- Interest rate spread: 10-year Treasury minus fed funds rate
- Consumer expectations: Sentiment drives spending
LEI Track Record
Before the 2008 recession:
- LEI peaked in July 2006
- Recession began December 2007 (17-month lead)
- 6 consecutive months of decline before recession started
Before the 2020 recession:
- LEI was still rising into February 2020
- COVID was an external shock - not predictable by LEI
- This shows LEI works for economic recessions, not sudden external events
Key Individual Leading Indicators
The Yield Curve
The yield curve (specifically the spread between 10-year and 2-year Treasury yields) is perhaps the most reliable recession predictor. When this spread goes negative (inverts), a recession has historically followed within 6-24 months.
- Has inverted before every recession since 1955
- Only two false signals in that period
- Average lead time of 12-18 months before recession
Building Permits
Housing is extremely interest-rate sensitive, making building permits an excellent leading indicator. When permits decline, it signals reduced construction activity and often precedes broader economic weakness.
- Leads the economy by 6-12 months
- Affects construction jobs, materials demand, appliance sales
- Multiplier effect through the economy
Initial Jobless Claims
Weekly initial unemployment claims provide the most timely read on the labor market. Rising claims indicate employers are starting to cut workers, often before it shows up in the monthly jobs report.
- Released weekly (most timely indicator)
- Four-week moving average smooths volatility
- Watch for sustained trend changes, not single weeks
Stock Prices (S&P 500)
Stock prices are themselves a leading indicator because they reflect investors' expectations about future corporate earnings. The market often begins declining 6-9 months before a recession begins.
Important caveat: Stock prices can decline without a recession following (think of the 2022 bear market). Use stock prices in conjunction with other indicators, not in isolation.
How to Use Leading Indicators in Trading
Strategy 1: Monitor the LEI Trend
Track the month-over-month change in the LEI:
- Three or more consecutive declines warrants caution
- Six consecutive declines historically signals recession risk
- Year-over-year changes provide additional context
Strategy 2: Watch Yield Curve Inversions
When the yield curve inverts:
- Consider gradually reducing equity exposure
- Increase allocation to defensive sectors
- Build cash positions for opportunities ahead
- Do not panic immediately - recession may be 1-2 years away
Strategy 3: Sector Rotation
As leading indicators turn, rotate between sectors:
- LEI declining: Favor utilities, healthcare, consumer staples
- LEI bottoming: Begin adding cyclicals, small caps
- LEI rising: Favor industrials, technology, consumer discretionary
- LEI peaking: Reduce cyclical exposure, raise cash
Trading the LEI
Simple rule-based approach:
- LEI up year-over-year: Stay invested in stocks
- LEI down year-over-year: Reduce equity exposure by 25%
- LEI down 4%+ year-over-year: Reduce equity exposure by 50%
This simple approach would have helped avoid much of the 2008 decline.
Other Important Leading Indicators
PMI Manufacturing
The Purchasing Managers Index above 50 indicates expansion, below 50 indicates contraction. Watch for the direction of change, not just the level.
Consumer Expectations
Part of consumer confidence surveys, expectations about future conditions lead actual spending changes.
Money Supply Growth
Rapid money supply growth often precedes inflation and asset price increases. Contracting money supply can signal future economic weakness.
Copper Prices
Known as "Dr. Copper" for its economic forecasting ability. As an industrial metal used in construction and manufacturing, copper demand reflects economic activity.
Limitations of Leading Indicators
Keep these limitations in mind:
- False signals: Not every decline leads to recession
- Variable lead times: Can range from 6-24 months
- External shocks: Cannot predict pandemics, wars, or other sudden events
- Policy responses: Fed actions can prevent predicted recessions
- Revision risk: Data is often revised after initial release
Building Your Indicator Dashboard
Create a simple dashboard tracking key leading indicators:
- Conference Board LEI (monthly)
- Yield curve spread (daily)
- Initial jobless claims (weekly)
- Building permits (monthly)
- ISM Manufacturing PMI (monthly)
When multiple indicators turn in the same direction, the signal is stronger.
Track Your Trades Against Economic Conditions
Pro Trader Dashboard helps you analyze how your trading performance correlates with economic conditions. See which strategies work best in different economic environments.
Summary
Leading economic indicators help predict economic turning points before they occur. The Conference Board LEI combines 10 components, with the yield curve, building permits, and jobless claims being particularly important. While no indicator is perfect, monitoring leading indicators together provides valuable information for positioning your portfolio. When multiple indicators turn down, get defensive. When they turn up, consider adding risk.
Want to learn more? Read about coincident economic indicators or explore lagging indicators.