Archimedes Finance

Become a better investor


Economic indicators

Lesson in Course: Market movements (beginner, 12min )

The direction of the economy and the business cycle we are currently in effects the stock markets. How will I know if the economy starts changing before it's too late?

Policymakers and investors keep a close eye on the state of the current economy. While the economy is not the same as the stock market, understanding the stages of the economy helps us effectively manage our risk. We've already previously learned that GDP serves as a scorecard or snapshot of the current economic health. Apart from GDP, there are other key indicators to the economy. These indicators include unemploymentmanufacturing activity, new homes purchased, new construction, inflation, and consumer confidence.

These indicators all help provide an overall view of the economy and shouldn't really stand on their own. To better understand, we can break these indicators down further into groups of leading indicators, lagging indicators, and coincident indicators.

 

Leading indicators

Leading indicators tend to change before the economy does. In the video, the example of slowing building permits shows less demand and signals a slowdown in the economy. Leading indicators can tip us off on pending trouble and are essential to pay attention to. However, it is important to note that leading indicators may not always predict the future. In the example above, building permits could have been slow due to bad weather or a lack of supplies from a vendor. 

Instead, looking at more prominent trends of leading indicators gives us a clearer picture devoid of one-off factors.

New construction

The US Commerce department surveys home builders across the country and releases a Housing Start report once a month that summarizes building permits, housing starts, and housing completions data. 

The drop-off in Housing Start in April 2020 in Home Starts is due to Covid-19.

Outside of showing demand for new homes, the Housing Start report also sheds some light on other industries. For example, fewer homes mean fewer mortgages, thus impacting the banking and financial sector. Additionally, fewer new homes mean fewer homeowners are purchasing appliances, furniture, and other household goods resulting in decreased consumer spending.

Manufacturing

Manufacturing levels can signal what's to be expected for this quarter's GDP calculation. 

High levels of manufacturing signal economic expansion, and lower levels of manufacturing may signal an economic contraction. Therefore, the Institute for Supply Management (ISM) surveys senior executives at over 400 companies in major industries on new orders, inventory levels, production, supplier deliveries, and employment. The results are published monthly in the Purchasing Manager's Index (PMI) report.

2019-May 2020 PMI

We can see the effects of COVID-19 sheltering-in-place and quarantine measures on the US PMI in April 2020. 

Consumer Confidence

The Conference Board polls roughly 5,000 households regarding how optimistic or pessimistic the household members are about their expected financial situation. 

The results are compiled and reported as a Consumer Confidence Index (CCI). Confident consumers spend freely without worry and are great for the economy. Increased revenue for businesses results in more consumers employed, which leads back to more spending. When we are not confident in our economic future, we are more likely to save instead of spend. Less spending leads to less revenue for businesses and starts an economic contraction. For the US, a CCI above 100 represents strong confidence.

A distinction on CCI

Some economists in the past have considered CCI as a lagging indicator. Archimedes, in addition to the OECD and many others, considers CCI to be a leading indicator. We believe that consumer spending drives the economy and not necessarily the other way. For example, after a prolonged recession, the economy is in bad shape. If consumers made their decisions based on the state of the economy, most would not spend, and recovery wouldn't be possible.

All three leading indicators reports point towards significant contraction for April and May of 2020. While this is not a surprise, the Fed responded with monetary policy adjustments to reduce the magnitude of the contraction felt by the economy due to COVID-19. 

Lagging indicators

Lagging indicators change after the economy changes and confirm what investors and economists suspected from the leading indicators.

New home sales

The New Home Sales is a monthly report published by the US Census Bureau. 

This lagging indicator should follow the trend in consumer confidence over time. During times of strong economic growth, people feel more secure in their jobs and are more likely to decide to buy large purchases such as homes. Conversely, in times of economic uncertainty or unemployment, consumers would prefer to save and will forgo expensive purchases. Banks are also more conservative in the availability of mortgages to consumers during an economic recession, driving home sales down further.

Inflation

The Consumer Price Index (CPI), used to index the cost of living, measures the changes in the inflation rate reported by the US Bureau of Labor Statistics monthly.

 The CPI is the change in the cost of consumer goods and services such as transportation, food, and medical care. The Federal Reserve monitors the inflation measurements and unemployment numbers to enact monetary policies. In times of economic expansion, we can expect higher than average inflation or rising CPI, and during an economic contraction, we can expect less purchasing power and a low CPI.

 

Coincident indicators

Coincident indicators help show the current health of the economy. While coincident indicators still take some time for organizations to collect, they are the closest indicators available to understand what's happening now.

GDP

GDP summarizes all the transactions in a quarter that produce goods and services in a country.

For the US, the BEA (Bureau of Economic Analysis) reports and revises our GDP. The economy expands when we produce more goods and services. On the contrary, fewer goods and services result in economic contraction.

Unemployment

Unemployment rate and duration are measured and reported by the US Bureau of Labor Statistics and published monthly as the Jobs Report

The report surveys households and employers to estimate the number of people employed and unemployed in the economy. Low unemployment, typically below 4%, is an indication of economic expansion. High unemployment, double digits percentages, is an indication of economic contraction. Our central bank, The Federal Reserve, uses unemployment numbers to guide monetary policy decisions.

While these reports come out monthly, we should pay close attention to the leading and coincident indicators as everyday investors. Lagging indicators are usually only helpful to confirm the economic outlook and rarely provide an opportunity for us to be proactive.

Most financial news outlets will report on the leading and coincident indicators. If these indicators start sounding alarms, it would be a good time for us to de-risk some of our portfolios. Likewise, if we continue to see signs of strong expansion, we can afford to take more risks.

Glossary

What is Jobs report?

Monthly report on the unemployment rate and duration reported by the US Bureau of Labor Statistics.

What is Consumer price index (CPI)?

The Consumer Price Index (CPI) is the measurement of the changes in the inflation rate and is used to index the cost of living. The US Bureau of Labor Statistics reports CPI on a monthly basis as the change in prices of consumer goods and services such as transportation, food, and medical care.

What is Consumer Confidence (CCI)?

The Conference Board polls roughly 5,000 households regarding how optimistic or pessimistic the household members are about their expected financial situation. The results are compiled and reported as a Consumer Confidence Index (CCI).

What is Housing Start?

The US Commerce department surveys home builders across the country and releases a Housing Start report once a month that summarizes building permits, housing starts, and housing completions data.

What is Purchasing Manager's Index (PMI)?

The Institute for Supply Management (ISM) surveys senior executives at over 400 companies in major industries on new orders, inventory levels, production, supplier deliveries, and employment.

 

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

Join our investment learning hub for more free lessons like this, connect with our trusted community, and get hands-on experience by playing a game!

Sitemap