Thursday, April 2, 2009

Economist's Notebook: Leading and Lagging Indicators

Jessica, a reader, e-mailed me suggesting I post about the contrasting economic news coming from the stock market and the labor market in the context of leading and lagging indicators. Good idea and thanks for the suggestion Jessica.

Let's start with the stock market. The Dow has made some pretty significant gains in recent weeks. It reached a low if 6547 on March 9 and is about to close the day today at around 8000. But the stock market is notoriously fickle and most economists downplay its worth as a good economic indicator. Still, almost a year ago in May 2008 it closed above 13,000 the subsequent erosion in equity value has hurt a lot of Americans, many of whom now have retirement funds invested in these markets. The loss of wealth that was the result of this erosion in stock price has led to people cutting consumption spending and staying in or re-entering the labor market. These two things lead to reduction in aggregate demand and increased unemployment respectively. So, while the Dow (or the better S&P 500) may be a fickle economic indicator, there is no doubt that it is a key component of our economy and as such is one leading indicator - something that generally precedes an economic recovery or gets better before the general economy does. So why do economists shrug when they observe the recent upturn in the Dow?, well here is a look at the DJIA from 1931 to 1934:

Notice how in the summer of 1932 the Dow surged? What that the end of the great depression? No. Spring of 1933, same thing. We have seen this time and again in recessions, so we tend to be pretty weary of placing too much weight on the Dow as an economic indicator. Perhaps it is best described as a necessary but not a sufficient condition for economic recovery - that fact that it is rising is necessary for economic recovery, but it could rise even though we are not in recovery yet. [On a related note, what Wall Street likes in the Geithner plan is not necessarily what is best for the economy]

Now let's contrast this with employment. First off, the BLS will announce the March US unemployment figures tomorrow morning and from all indications it is going to be gruesome. Unemployment insurance claims are up, the ADP report is bad, and no one seems to be adding jobs right now. But unemployment is a lagging indicator, it is about the last thing that will start to turn positive even though it is about the most important indication of how people are suffering from the economic downturn. Why will it lag? Well businesses are reluctant to make the big commitment to new employees unless they are very confident that they need them. As they currently have a lot of employees who are working less than full time and can ramp up hours and even overtime, thus new hiring will be dealyed until they can't squeeze more productivity out of their current workforce. Also as the economy turns better, more discouraged people - people who stopped looking for work - will re-enter the market. This will counteract the effect of job creratin in the unemployment numbers, and thus unemployment will be slow to get better. Here is a look at the rapid deterioration in labor market in the US. It is going to keep getting worse until the end of the year, in my opinion.
Tomorrow morning I'll be looking at the BLS unemployment numbers. Job losses of around 650,000 are the expectation. Which is just terrible. But I would not be surprised to see a number closer to 700,000.

So what am I looking at as other leading indicators (things that have to start changing first for the economy to stat to right itself)? Well, since this crisis started as a credit crisis and asset/wealth depletion crisis, it has led to a huge decrease in consumption and investment. So one thing I am looking at are a few things that indicate the health of credit markets (which need to get better in order for the rest of the economy to get better). There has been some good improvement in these indicators since the peak of the crisis, but we still see troubles like the indicator for the health of corporate debt (a lot of creditors are still worried about the creditworthness of businesses). I am also looking at indications that consumers a starting to spend again, so recent small upticks in auto sales, pending home sales , while too small and preliminary to signify much, are nonetheless welcome possibilities that things are starting to ease. Other indicators like consumer confidence are important leading indicators as they relate to how much consumers might start spending based on how worried they are about the future.

On the business side we can look for evidence of declining inventories and increased orders and industrial activity. I consider these sort-of real time indicators. Why? Suppose consumers start to spend more in stores, stores will eventually start to need to replace stock this will first draw down inventories, then will spark new industrial activity and then new business investment. Here we are still seeing contraction, but at a slightly slower rate. So that's not great. Market info for residential home sales (values, median prices, volumes) are also more real-time than leading or lagging (though we often get them late) because they are based on ex-post transactions.

I should note that I did not mention construction permits here (which are typically leading indicators) because construction activity is much further down the recovery road in my opinion. First we have to absorb all of the unsold capacity.

You may have noticed that many of my links are to the Calculated Risk blog, which is my one-stop shop for most of these indicators. I highly recommend it.

So what are some things that I did not mention that you look at?


Jessica said...

Honestly, I was hoping that your factual and evidence based analysis would be more optimistic. Darn. I am hopeful that this ends sooner than the end of the year but I realize that the experts are thinking that would be the earliest. So few consumers actually understand all the underlying factors and indicators that one can always hope that a short term bump in the market will inspire unfounded confidence in the masses thus spurring spending and pullling us out of this recession. See, this is why I wouldn't be a good economist!! Thank you so much, though, for the quick AND insightful post.

Patrick Emerson said...

Well, the result of the G20 summit was much better than I was (pessimistically) expecting, so my expecatations about the recovery have just gone up.

lisamona said...

I like my own cheese count. As the ripples of the recession lap against our community bedrock, the not whole foods but good food store, the cheese count dwindles. First there was the fake grapes (PVC ewh!), then the conspicuously fanned recipe cards, finally a cheese department consolidation. The number of artsy crafty cheeses no longer warranted a separate section. Now the goat gouda sits next to the tillomook brick. Noticable is also a change in proportion of hard to soft cheeses with the hard cheeses gaining. I am keeping track since I will list my home again once the cheese count improves.

dw3 said...

Emerson, i like what you wrote...well thought out. Thanks.

Lisamona, i like your sense of humor.

In addition to what you stated in your blog, I look at GOLD. It's a short-term and long term indicator in my opinion. Also, thanks for the Calculated Risk link.