What the Index of Leading Economic Indicators is Really Telling Us

By: Money_and_Markets

Claus Vogt writes: The Conference Board’s Index of Leading Economic Indicators (LEI) is an outstanding tool to predict recessions. This index is reported monthly and is made up of economic components that can reflect upcoming changes in the overall economy. Since 1960 it has been extremely reliable, and it played an important role in my 2007 recession forecast.

Of course there’s no perfect indicator, and the LEI is no exception. Its handicap is a huge time lag. In fact, it may take up to six quarters from the time the LEI’s recession signal is given until the arrival of the downturn.

And the same holds true in the opposite case, when the LEI is signaling the end of a recession.

The LEI Is Up on a Monthly Basis, But Still Down Year-Over-Year

In May the LEI rose 1.2 percent after a revised 1.1 percent increase in April. This was the best back-to-back performance since November-December 2001. At first glance this is an encouraging development, especially considering that the LEI had been on a general downtrend since reaching a peak in July 2007.

It’s no surprise then that the bulls are treating this as a sign that a strong economic recovery is just around the corner. These bulls, by the way, are the same ones who ignored the LEI’s recession warning during all of 2007.

Since it’s such a slow working indicator, I use the LEI exclusively on a year-over-year change basis. So here’s my recession-forecasting rule: The year-over-year percentage change of the LEI must be negative for three consecutive months before a recession signal is given.

I don’t want to jump to conclusions. So I follow a simple rule when using the LEI to forecast the end of a recession.

The opposite is my rule for forecasting the end of a recession: The LEI must show a positive year-over-year percentage change for three consecutive months.

I use these rules because I don’t want to jump to conclusions, so I give the economy and the LEI enough time to tip the scales.

It now looks as if March was the bottom for the LEI with a reading of -4 percent year-over-year. And the first quarter of 2009 might confirm this. However, the well-known time lag mentioned above tells us to keep our patience in looking for the next boom to begin.

In addition, there’s more to the recent LEI report than appears in the headlines …

Under the Surface The LEI’s Message Is Fragile

The LEI is a weighted average of 10 components. They can be split into financial variables, survey variables, and economic variables. This distinction is important, especially during the current cycle …

That’s because the current cycle is the result of a huge real estate bubble. And financial history teaches us that monetary policy loses a lot of its effectiveness when a bubble bursts. So it makes a lot of sense to have a closer look at the LEI’s components.

Here’s what I’ve found:

The number of new building permits issued is just one of the economic variables included in the LEI.

Financial and survey variables were fully responsible for the positive LEI during the last two months. Whereas the five economic variables made no positive contributions at all! Collectively, average hours worked, jobless claims, real consumer goods orders, real core capital goods orders, and building permits were even slightly negative.

Historically, an ending recession was preceded by the economic variables joining the positive development of the other variables. Hence I caution you not to become too bullish on the economy just yet.

Even the Financial Variables Are Somewhat Shaky …

The weighting of the financial components in the LEI is 63.6 percent. So it’s clear that the LEI’s recent positive performance relied mainly on the growth of the real money, the stock market rally, and a rising interest rate spread.

As I’ve written in my previous Money and Markets columns, rising stock prices may turn out to have been just a bear market rally. And falling long-term Treasury bonds — not rising short-term rates — are responsible for the expansion of interest rate spreads.

Both trends seem to be on the verge of reversing: The bear market rally looks to be over, and Treasury bonds have fallen too much, too fast. A medium-term correction is overdue and has probably already begun.

The LEI is not giving a green light yet. And that’s one more reason to keep a cautious stance towards the economy and the stock market.

Best wishes,

Claus

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