Define "Leading Indicator"

by Cam Merritt

    Investors are constantly on the lookout for signs of what's going to happen -- either in the economy as a whole or just one small corner -- so they can be in the right position to make a profit. That's why leading indicators are so important. They provide clues about what's likely to happen next.

    An indicator can be any bit of economic data. A leading indicator is one that signals an economic trend that is developing or has yet to develop. For example, if you want to know how many refrigerators an appliance maker is producing, you could go to the plant and count them as they come off the line. That's an indicator of current production, also known as a coincident indicator. If you want to know how many fridges it will be making six months from now, look at the orders coming in from stores and home builders. Those orders are leading indicators.

    If you pay attention to economic news, you may have heard of the "Index of Leading Economic Indicators" or the "Leading Economic Index." This is a widely followed index created by the Conference Board, an independent economic research group. It keeps track of 10 major leading indicators for the state of the U.S. economy and uses them to generate predictions for economic growth. It includes such indicators as initial claims for unemployment benefits, orders received by manufacturers, orders placed by manufacturers for production equipment, building permits issued for new housing and surveys of consumer expectations.

    Just about every industry has its own leading indicators. Investors and financial analysts interested in an industry study its indicators for signs that business will improve, deteriorate or stay steady. For example, a surge in housing construction or a decline in mortgage rates suggests more home sales in the coming months. That would be good news for furniture manufacturers and retailers, as home buyers often need new furniture for their new spaces. Therefore, housing starts and mortgage rates would be leading indicators for the furniture industry.

    Something gets tagged as a leading indicator because it has a fairly consistent history of preceding future economic activity. But it's still no guarantee that such activity will materialize. No data can predict the future. In some cases you can't really tell whether an economic trend has developed until it shows up in the opposite of a leading indicator -- a "lagging indicator." These are indicators that result from changes in the economy; investors and analysts use them to confirm trends. For example, employment tends to be a lagging indicator. Companies generally don't add workers in anticipation of things getting better; they do so once things actually do get better.

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    About the Author

    Cam Merritt has been a professional writer and editor since 1992, specializing in articles about spectator sports, personal finance and law. He has contributed to "USA Today," "The Des Moines Register" and the "Better Homes and Gardens" family of magazines and websites. Merritt has a Bachelor of Arts in journalism from Drake University.

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