Virtually any investor would agree that if you knew precisely what was yet to come, it would likely help you position your portfolio effectively. Of course, no one can know the future with certainty. But with good data, you can get at least a general view of where the economy is likely headed—useful, considering economic trends heavily influence the earnings environment for stocks. In Fisher Investments’ view, The Conference Board’s Leading Economic Index (LEI), a composite of mostly forward-looking economic data, gives investors a good look into upcoming economic growth trends. We think understanding its components—and what to look for—can help you navigate markets better.
The LEI dates back over 70 years. After the Great Depression, economists at the National Bureau of Economic Research (NBER) sought to find data patterns that could help them spot future recessions. Their analysis found certain data series tended to move ahead of economies fairly often. These researchers then took these series, weighted them and created the LEI, a single index aimed at predicting economic trends over the next few months. Since the LEI debuted in 1950, three other organizations have administered the Index—and The Conference Board, a nonprofit research group, now publishes it. Through the years, LEI administrators have adjusted its components to align with the evolving global economy, latest economic theory and data collection methods.
The United States’ LEI uses 10 indicators. The exhibit shows its current constituents, in place since 2011.
Exhibit: LEI Components
Now, not all of these components are equal, in Fisher Investments’ view. Some are inherently forward-looking. Manufacturers’ new orders and the ISM New Orders Index have a fairly clear forward-looking nature, as today’s new orders are tomorrow’s production. Building permits for private housing are also forward-looking, but we think they have minimal impact as residential housing represents only 4.7% of US GDP.[i] Interest rate spreads—the difference between short- and long-term rates—indicate banks’ profit margins. They borrow at short rates and lend at longer ones, so when long rates comfortably exceed short rates, lending is quite profitable. That gives banks an incentive to lend broadly—spurring economic growth. The Leading Credit Index uses variables including margin lending at US broker-dealers and the US Federal Reserve’s Senior Loan Officer Opinion Survey to assess future credit conditions.
Stocks—specifically, the S&P 500—are also included in the LEI. These are forward-looking, in Fisher Investments’ view, as shifts from bull market to bear market (and vice-versa) often precede cyclical changes in the economy. But if your interest is stocks, you must discount this component. You can’t forecast stocks with stocks—past performance isn’t predictive. Furthermore, the LEI doesn’t simply look at monthly returns: It compares the average daily closing level to the prior month’s, “smoothing” returns—but even then, short-term volatility can present false signals.
Other components are less forward-looking, in our view—more backward-looking or coincidental at best. Consumer confidence surveys often reflect participants’ feelings about the present or very recent past. They don’t really predict behavior, according to Fisher Investments’ research. Weekly initial jobless claims and manufacturing hours cover current labor market conditions, which lag the economy. Growth begets hiring.
In Fisher Investments’ view, the Leading Credit Index (LCI) and interest rate spread tend to be the swing factors, regularly flashing warnings ahead of contractions and generating far fewer false reads. They aren’t perfect, but they are about as consistent as possible. Historically, if the yield curve inverts—meaning short-term interest rates exceed long-term rates—lending becomes unprofitable, freezing credit markets. A recession will typically follow at some point in the relatively near future.
Again, this Index does not forecast stock prices. Investors should use the LEI for a better idea of the economy’s direction only. However, economic trends do influence stocks’ earnings, with recessions often following bear markets closely, in Fisher Investments’ experience. Therefore, observing the LEI’s components—especially those we consider consistent swing factors—can provide you with an advantage, in our view. It can help you move ahead of the crowd when readings trend downward, or remain disciplined when they move upward. This is no magic bullet—and further analysis is likely still required. But there can be big benefits from studying the LEI, in Fisher Investments’ view.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
Sources:
[i] Source: Federal Reserve Bank of St. Louis, as of 03/07/2022. Private residential fixed investment as a percentage of GDP, Q4 2021.