Forecast Friday Topic: Leading Indicators and Surveys of Expectations

(Thirty-second in a series)

Most of the forecasting methods we have discussed so far deal with generating forecasts for a steady-state scenario. Yet the nature of the business cycle is such that there are long periods of growth, long periods of declines, and periods of plateau. Many managers and planners would love to know how to spot the moment when things are about to change for better or worse. Spotting these turning points can be difficult given standard forecasting procedures; yet being able to identify when business activity is going to enter a prolonged period of expansion or a protracted decline can greatly enhance managerial and organizational planning. Two of the most common ways managers anticipate turning points in a time series include leading economic indicators and surveys of expectations. This post discusses both.

Leading Economic Indicators

Nobody has a crystal ball. Yet, some time series exhibit patterns that foreshadow economic activity to come. Quite often, when activity turns positive in one time series, months later it triggers an appropriate response in the broader economy. When movements in a time series seem to anticipate coming economic activity, the time series is said to be a leading economic indicator. When a time series moves in tandem with economic activity, the time series is said to be a coincident economic
indicator; and when movements within a particular time series trails economic activity, the time series is said to be a lagging indicator. Economic indicators are nothing new. The ancient Phoenicians, whose empire was built on trading, often used the number of ships arriving in port as an indicator of trading and economic activity.

Economic indicators can be procyclic – that is they increase as economic activity increases and decrease when economic activity decreases; or countercyclic – meaning they decline when the economy is improving or increase when the economy is declining; or they can be acyclic, having little or no correlation at all with the broader economy. Acyclic indicators are rare, and usually are relegated to subsectors of the economy, to which they are either procyclic or countercyclic.

Since 1961, the U.S. Department of Commerce has published the Survey of Current Business, which details monthly changes in leading indicators. The Conference Board publishes a composite index of 10 leading economic indicators, whose activity suggests changes in economic activity six to nine months into the future. Those 10 components include (reprinted from Investopedia.com):

  1. the average weekly hours worked by manufacturing workers;
  2. the average number of initial applications for unemployment insurance;
  3. the amount of manufacturers’ new orders for consumer goods and materials;
  4. the speed of delivery of new merchandise to vendors from suppliers;
  5. the amount of new orders for capital goods unrelated to defense;
  6. the amount of new building permits for residential buildings;
  7. the S&P 500 stock index;
  8. the inflation-adjusted monetary supply (M2);
  9. the spread between long and short interest rates; and
  10. consumer sentiment

 

These indicators are used to measure changes in the broader economy. Each industry or organization may have its own indicators of business activity. For your business, the choice of the time series(‘) to use as leading indicators and the weight they receive depend on several factors, including:

  1. How well it tends to lead activity in your firm and industry;
  2. How easy the time series is to measure accurately;
  3. How well it conforms to the business cycle;
  4. The time series’ overall performance, not just turning points;
  5. Smoothness – no random blips that give misleading economic cues; and
  6. Availability of data.

Over time, the use of specific indicators, and their significance in forecasting do in fact change. You need to keep an eye on how well the indicators you select continue to foreshadow business activity in your industry.

Surveys of Expectations

Sometimes time series are not available for economic indicators. Changes in technology social structure may not be readily picked up in the existing time series. Other times, consumer sentiment isn’t totally represented in the economic indicators. As a result, surveys are used to measure business optimism, or expectations of the future. Economists and business leaders are often surveyed for their opinions. Sometimes, it’s helpful to know if business leaders anticipate spending more money on equipment purchases in the coming year; whether they plan to hire or lay off workers; or whether they intend to expand. While what respondents to these surveys say and what they really do can be quite different, overall, the surveys can provide some direction as to which way the economy is heading.

Next Forecast Friday Topic: Calendar Effects in Forecasting

Easter can fall in March or April; every four years, February has an extra day; in some years, months have four weekends; others years, five. These nuances can generate huge forecast errors. Next week’s Forecast Friday post discusses these calendar effects in forecasting and what you can do to adjust for them.

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One Response to “Forecast Friday Topic: Leading Indicators and Surveys of Expectations”

  1. New Indicators to Predict the Economy? « Insight Central Says:

    […] Indicators to Predict the Economy? By analysights In the December 9 Forecast Friday post, I discussed the use of economic indicators when predicting a time series. In that post, I […]

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