Understanding the U.S. Leading Economic Index (LEI): An Essential Indicator for Market Trends

The health of a nation's economy is critically important to policy makers, businesses, and investors. Various economic indicators can provide clues about the future direction of an economy, and one of the most significant among them is the Leading Economic Index (LEI). Below, we delve into the intricacies of the LEI, its components, and why it matters.

What is the US Leading Economic Index?

The LEI is a composite index published monthly by The Conference Board, a non-profit business research organization. The LEI is designed to predict future movements of the economy, giving a forward-looking snapshot of economic trends, typically spanning six to twelve months into the future.

The LEI is one of three business cycle indicators released by The Conference Board, the other two being the Coincident Economic Index (CEI) and the Lagging Economic Index (LAG). While the CEI provides a measure of current economic activity and the LAG indicates economic changes that have already occurred, the LEI aims to forecast upcoming trends.

Components of the LEI 

The LEI comprises ten components, each representing different aspects of the US economy. These components include:

Financial Factors:

1. Stock prices of 500 common stocks – S&P 500
2. Leading Credit Index™ (inverted)
3. Interest rate spread (10-year Treasury bonds less the federal funds rate)

Non-Financial Factors:

1. Average weekly hours of manufacturing workers
2. Average weekly initial applications for unemployment insurance
3. Manufacturers' new orders for consumer goods and materials
4. ISM Index of New Orders
5. Manufacturers' new orders for non-defense capital goods excluding aircraft
6. Building permits for new private housing units
7. Average consumer expectations for business conditions
 

Each of these indicators tends to change before the economy as a whole changes, thereby giving us a 'lead' on the economy.

Why the LEI Matters

The LEI serves as an "economic thermometer," providing an indication of what's likely to come in the economic cycle. When the LEI rises, it suggests an expansion of economic activity in the upcoming months. Conversely, a decrease in the LEI predicts a contraction or slowing down of the economy.

For investors, the LEI can guide investment strategies. A rising LEI could indicate that market participants will favor cyclical industries that perform well during economic expansions, such as consumer discretionary companies or technology firms. On the other hand, a falling LEI might signal an upcoming downturn, suggesting a switch to defensive stocks like utilities or consumer staples, which tend to hold up better during economic contractions.

For businesses, the LEI can influence strategic decisions. If the LEI indicates an economic expansion, businesses may choose to invest in new projects, hire more employees, or increase production. Conversely, a falling LEI may lead businesses to tighten their belts, delaying expansion plans or reducing their workforce.

Historical Correlation Between the LEI and Recessions

The LEI has a historical tendency to peak and decline prior to a recession, which has led many economists and investors to view it as a reliable indicator of upcoming downturns.

Historically, consistent declines in the LEI over several months, typically leading to a level that is lower than the peak level 6 - 12 months prior, have often been followed by recessions. For instance, before the onset of the 2007-2009 Great Recession, the LEI started to drop in 2006, signaling a potential contraction in economic activity. Similarly, the LEI peaked in 2000 before the 2001 recession and in 1989 before the recession in the early 1990s.

However, it's crucial to remember that while the LEI is designed to forecast potential changes in the economic climate, it's not infallible. There have been instances where the LEI has indicated a potential downturn, but a recession did not follow. This is sometimes referred to as a "false positive".

It's also essential to note that while the LEI is generally reliable in predicting the direction of the overall economy, it doesn't provide specifics about the severity or duration of a potential recession. Therefore, while the LEI is a valuable tool in economic forecasting, it should be used alongside other indicators and data sources to form a comprehensive view of economic conditions.

Conclusion

The LEI provides valuable insights into the future direction of the economy, making it an indispensable tool for investors, businesses, and policymakers. However, like any economic indicator, it should be used as part of a broader toolkit. By combining the LEI with other economic indicators and market analysis, you can make more informed decisions and better anticipate changes in the economic landscape.