Magic Crystal Ball

One of the weirdest questions we hear these days is: “where can I buy the alarm clock that is going to wake me up when the recession is over?” Though there is no one-formula-fits-all type economic indicator that can accurately forecast the movement of the economy as the business cycle enters different phases, I would bring up for discussion an interesting composite index released in US by the Conference Board: the Leading Economic Indicator (LEI). The index increased 0.7% in June versus a revised 1.3% gain in May and a 1.2% jump in April. The June increase puts the year-to-year decline at 1.18%. The trough for the year-to-year change appears to have occurred in December 2008 (-3.98%).
Generally, people tend to overreact and swing perception in a very short period of time. The sentiment shift, based on high-frequency data, is even harder to understand in light of the economy’s steady performance. Weak numbers yield a weak outlook. Strong numbers mean good times ahead. That makes the economic indicators forecasting power difficult to rely on. The composite index is a key element in an analytic system designed to signal peaks and troughs in the business cycle. The ten individual leading indicators are constructed to summarize and reveal common turning point pattern in economic in a more convincing manner than any single economic indicator alone. For instance, the LEI index for the US rose in July marking its fourth consecutive increase. The interest rate spread, initial unemployment claims and the average workweek made large positive contributions to the index in July, more than offsetting the negative contributions from consumer expectations, real money supply, and building permits.
The biggest contribution to the index (i.e., 46 percent) is brought by the Money Supply (M2) and the Interest Rate Spread (10-year Treasury – Fed Funds). When short rates are relatively low and long rates are relatively high, the economy tends to revive. With less contribution to the aggregate number, Building Permits is the housing indicator that plays a significant role in the revival stage of the overall economy. As the historical data shows, housing starts normally begin to slow about a year prior to the beginning of a recession, and usually fall for about 9 months into a recession, for an average drop of 25 percent from peak-to-trough. During this cycle, housing starts peaked more than two years ago and have already fallen by more than 50 percent. In a typical recession, housing starts turn up about 9 months into the contraction.
Other critical LEI index components are the Average Weekly Hours in Manufacturing and the Weekly Initial Jobless Claims. The average hours worked per week by production workers tend to lead the business cycle because manufacturers adjust work hours before changing their headcount. The claims for unemployment insurance have averaged 570,000 over the last four weeks. As the theory teaches us, the unemployment rate usually turns up noticeably a couple of months into a contraction.
Far from being a perfect indicator, the Stock Market represents a major LEI index component with a good predictable power on the overall economy. As the theory shows, on average, the market peaks about six months prior to the start of a contraction and begins to decline more aggressively as the contraction begins. Based on the 9 previous recessions since 1953, the market bottomed an average of 6 months into the recession (the average recession has lasted 11 months). But this average masks a lot of variability. There have been important bear markets that lasted longer. The market bottomed 18 months after the beginning of the 2001 recession and 10 months after the start of the 1973 recession.
Completing the Leading Economic Indicator components list are the Manufacturers’ New Orders and the Index of Supplier Deliveries. As the theory states, new orders index tends to be an early mover. New orders eventually turn into production, inventory and sales, so the index can be a reliable leading indicator of economic activity. Although it is a volatile measure, it may be one of the first measures to turn up. Historical data shows that the new orders index has bottomed about 6 months into recessions. Similarly, the change in business inventory has become an important leading economic indicator as it indicates changes in consumer demand.

The year-to-year change of the LEI tracks the trough of the business cycle with a small lead. The mean and median leads of the year-to-year change in the LEI with reference to the troughs of the business cycle are 6.1 months and 7.0 months, respectively. The longest lead was in the 1981-82 recession and the smallest was during the mini-1980 recession. Based on history, it appears that a recovery in the latter half of 2009 is gaining support. So, all we have to do is set-up the alarm clock and fall asleep.

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