Leading Indicators: Definition and How They’re Used by Investors

What Is a Leading Indicator?

A leading indicator is a measurable set of data that may help to forecast future economic activity. Leading economic indicators can be used to predict changes in the economy before the economy begins to shift in a particular direction. They have the potential to be useful for businesses, investors, and policy makers.

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

Understanding Leading Indicators

Leading indicators must be measurable to be useful as predictors of where the economy may be headed. Policy makers and central bankers use leading indicators 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’ 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. These can include the housing market, retail sales, building permits, business startups, and more.

Examples of Leading Indicators

Purchasing Managers’ Index

Economists closely watch the Purchasing Managers’ Index (PMI). The PMI reflects trends in the manufacturing and service sectors and can be a useful signal of growth in a nation’s gross domestic product (GDP) due to changes in the demand for materials from corporations.

Durable Goods Orders

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

Consumer Confidence Index

Along with durable goods orders, many people consider the Consumer Confidence Index (CCI) 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.

Jobless Claims

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

Yield Curve

Many market participants consider the yield curve to be a leading indicator. Of particular interest is the spread between two-year and 10-year Treasury yields. This is because two-year yields in excess of 10-year yields have been correlated to both recession and short-term market volatility. If such an inverted yield curve occurs, it may signal that a recession is approaching.

Company Performance

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’ product quality or service failures. These can point to lower future revenue, growth, or profits. Conversely, positive customer satisfaction data may suggest that these factors will trend upward in the future.

Accuracy of Leading Indicators and How to Use Them

Conflicting Signals

Leading indicators are not always accurate. However, looking at several leading indicators 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. However, the historical lead time between turning points in capital goods and a specific target indicator such as changing stock prices or GDP may range from 12 to 24 months. You end up with data indicating a long lead time for action but low precision about when to take it.

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 the economy, but only over a few months or quarters. Such an indicator could provide detailed input for estimating the trends that affect your business or investments. But it might not provide that information in sufficient time to take full advantage of the insight gained. 

By themselves, both types of leading indicators might be helpful. Yet neither provides the full picture needed to maximize performance. In practice, this means that 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. Lagging indicators are data that reflect past economic performance. They're used to confirm economic change and financial market patterns.

Leading Indicators

• Measurable data that can indicate a potential upcoming change in the economy before it happens.
• They can alert users to specific economic changes and/or changing trends.
• Used by economists, analysts, businesses, and investors to predict and take action ahead of economic/financial change.
• Not always accurate and can be enhanced when studied with other economic data.
• They are based on data related to the activities of different areas of the economy.

Lagging Indicators

• Measurable data that reflects the effects of economic activity after it happens.
• They can confirm for users certain economic and business trends, quality of performance, and the impact of business decisions.
• Used by government, businesses, and investors to determine future strategies as they relate to proven (or unproven) assumptions and expectations.
• Data is considered reliable.
• They are based on facts and financial outcomes that relate to economic activities that previously occurred.

The Bottom Line

Leading indicators have the potential to be a highly valuable tool for economists, investors, business owners, and consumers. 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.