Economic Indicators For Dummies
Forecasting what will happen in the economic future is hard. Nobody gets it right all the time. However, with a grounding in economic indicators, you can improve your investment results and the profitability of your business.
How Are Economic Indicators Relevant to You?
Economic indicators were first published for government leaders who needed a better understanding of the country's current economic condition. Today, those indicators are useful across a wide variety of professions. Here's how economic indicators can help you:
Investors: Use economic indicators to fine-tune your investment strategies, improve your buy/sell decisions, and match your asset allocation decisions to the economic cycle.
Business leaders: Make better staffing-level and hiring decisions, match inventories to the business cycle (businesses that are sensitive to the economic cycle need larger inventories during periods of economic growth than during recessions), improve business forecasts, and evaluate new business opportunities based on current economic conditions.
Purchasing managers: Improve raw-material price forecasts and adjust negotiating strategies to lock in longer-term pricing agreements during periods of economic slowdown when material prices tend to be lowest.
Policy analysts: Use these information-laden reports to guide your economically sensitive policy decisions.
Business students: Develop a thorough understanding of economic indicators to improve your general business knowledge and make you more valuable to future employers.
Tracking the Economic Cycle from Expansion to Recession
The economy cycles through periods of growth and contraction. Knowing the following signs of each economic phase makes planning your investment or business strategies easier:
Expansion: During expansion, consumer spending is growing, especially for purchases of big-ticket products. Although interest rates are relatively low at the beginning of an expansion, they generally rise as the economy grows. Stocks that perform well during expansion include technology companies, durable goods manufacturers like auto companies, and so-called cyclical industries like steel manufacturers and construction companies.
Peak: At this point, most businesses are thriving. However, interest rates are climbing because investors and the Federal Reserve are concerned about the risk of rising inflation. Rising interest rates make new homes less affordable for some consumers. As a result, the number of layoffs rises in the housing sector and other interest-sensitive sections of the economy. The stock market typically anticipates economic peaks, so it's usually in decline by the time the peak arrives.
Recession: Early in recession, sales of consumer products like cars and kitchen appliances begin to fall, leading manufacturers to cut production and staffing levels. Unemployment rises, and personal income falls. Interest rates are generally highest at the beginning of a recession and fall throughout the recession. Most stocks perform poorly during a recession, but stocks of consumer staple companies (like those that produce food, beverages, and household and personal care products), pharmaceutical firms, financial companies, and dividend-paying utilities often hold their value because these firms sell goods and services that people need even when times are tough.
Trough: During an economic trough, businesses have lowered prices for big-ticket products enough to start attracting bargain hunters. The economy begins to find its footing as consumer spending starts to pick up. Sales of new homes often start to rise as buyers lock in attractive prices and low-interest-rate mortgages. The stock market tries to anticipate the coming economic expansion as transportation and cyclical stocks begin to rise.
The key to understanding the current economic situation is identifying when an economic expansion is over (when the peak has occurred) or when a new one is about to begin (when the trough has occurred). Though the periods of peak and trough are relatively brief and difficult to pinpoint, understanding economic indicators can help you identify them.
Leading, Lagging, or Coinciding: The Timeliness of Economic Indicators
Some economic indicators are better predictors than others. Knowing the major categories of indicators can help you identify which indicator is right for the job at hand. Here are the three main types of indicators, based on how timely they are:
Leading indicators: These indicators generally signal changes before changes actually occur in the economy. However, few leading indicators anticipate both expansions and recessions well. Examples of leading indicators include the New Residential Construction report (excellent for identifying a future expansion), the Consumer Sentiment Index (good for identifying an upcoming recession), and the PMI (formerly known as the Purchasing Managers' Index and a well-rounded indicator for identifying both expansion and contraction).
Lagging indicators: Changes in the economy occur before lagging indicators change. For example, employment as shown by the Employment Situation report tends to continue to fall or grow very slowly as the economy comes out of a recession (even though unemployment rates often rise as the economy enters a recession). Lagging indicators may not tell the future, but they're great for confirming where the economy has been and whether it's heading toward recession or expansion. If an indicator that lags recessions starts rising, for example, you can be quite sure that the trough has been reached and the expansion has begun.
Coincident indicators: These indicators may not offer much in the way of forecasting ability, but they do tell a lot about current economic conditions. Examples include the Gross Domestic Product (GDP) report and the Personal Income and Outlays report (specifically the personal income statistics).
Top Five Economic Indicators
Looking for the best economic forecasting tools? Here are a few investor favorites that you can use to improve your investment decisions:
Unemployment insurance: A rise in unemployment insurance claims is one of the earliest signs of a faltering economy. A one-week rise doesn't foretell a recession, but a persistent increase usually does. The Unemployment Insurance Weekly Claims Report tracks job losses throughout the country.
Personal spending: Consumers make the U.S. economy grow. When consumer spending rises, so does the economy. Likewise, when spending slows, a recession is likely to follow. Stay up to date with consumer spending habits with the Personal Income and Outlays report.
Consumer sentiment: Consumers cut back on their spending when they're worried about their financial future. The University of Michigan's Consumer Sentiment Index is an excellent way to find out if people are worried or optimistic about their economic future.
Business sentiment: Purchasing managers are the consumers of the business world, which is why it makes sense to ask them how businesses feel about the economy. The Institute of Supply Management does just that with its Manufacturing Report On Business®.
Inflation: When the Federal Reserve (the Fed) is on the lookout for inflation, it puts investors on pins and needles. If the Fed thinks inflation is rising, it'll put on the economic brakes by raising interest rates. Although knowledgeable investors and economists at the Fed use the PCE price deflator (PCE stands for personal consumption expenditures; the deflator is also called an implicit price deflator) to track inflation, the most popular inflation indicator is the Consumer Price Index (CPI).