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How to Invest with the Leading Economic Indicators

written by: Ginny Edwards•edited by: Rebecca Scudder•updated: 8/24/2010

Every investor, especially index investors, would love to have a crystal ball to see into the future and know where the stock market is heading. The Index of Leading Economic Indicators (LEI) TM is about as close as an investor can get in having his or her own personal crystal ball.

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    What Is the Index of Leading Economic Indicators?

    Leading Economic Indicators The Index of Leading Economic IndicatorsTM is an index comprised of 10 components which are considered to be early snapshots of economic activity in the United States. By monitoring the rise and fall of the index and each of its components, investors can determine if the green shoots of economic activity today foretell an abundant harvest tomorrow. The index is calculated by the Conference Board, a non-governmental organization, which determines the value of the index and the weight given to each of its components. The index has acted as an omen by turning downward before recessions, and as an early prognosticator by pointing upward before economic expansions – the reason for its attraction with index investors. However, the index of leading economic indicators is not full-proof and has been sharply criticized for predicting a non-recession in 2005 and being blind-sided by the recession of 1991-1992.

    Image Credit: Filomena Scalise / FreeDigitalPhotos.net

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    What are the 10 Leading Economic Indicators?

    1. Interest rate spread between 10-year Treasury notes and the federal funds rate. Known as the steepening of the yield curve, a rise in this indicator may forecast future economic growth as investors signal their expectations of economic expansion and possibly inflation by demanding higher rates of return for longer maturities.

    2. Inflation-adjusted, M2 measure of the money supply. M2 is the money supply in the economy which consists of currency, checking and savings accounts, traveler checks, and retail money market accounts. When the M2 supply rises there is more money available in financial institutions to lend to businesses for startup ventures that drive economic expansions.

    3. The average manufacturing workweek. The average workweek (also known as hours worked) is included in the monthly employment report published by the Bureau of Labor Statistics and is considered an early wake up call for job seekers because employers first address increases in consumer demand by boosting the working hours of current employees.

    4. Manufacturers' new orders for consumer goods and materials. Published by the Census Bureau, a rise in this indicator portends positive changes in actual production because new orders decrease inventory and contribute to unfilled orders, a precursor to future growth.

    5. S&P 500 measure of stock prices. The S&P 500 is an index comprised of 500 diversified large and mid-cap United States companies and reflects the broad-based health of the economy.

    6. Vendor performance component of the NAPM index. Complied by the National Association of Purchasing Managers (NAPM), vendor performance tracks the delivery time of orders to industrial companies with longer delivery times signaling a positive unanticipated rise in demand for manufacturing supplies.

    Continue reading on the next page for more on the leading economic indicators and some investing strategies in following their signals.

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    Understanding what are the components of the index of leading indicators is the first step in making better investment decisions. The index of leading economic indicators is good gauge of what the health of the economy will look like in 6 to 12 months. Learn how to invest better by using the leading economic indicators as your guide.
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    7. Average level of weekly initial claims for unemployment insurance. Compiled by the Bureau of Labor Statistics, the average weekly filings show the number of people filing for state jobless benefits during a four-week period. A drop in weekly claims may signal a ray of hope for job hunters who are waiting on deck for rehiring to begin. However, the correlation between fewer claims (fewer layoffs) and the resurgence of rehires (drop in the employment rate) is not perfectly correlated. Increased worker productivity and technological advances may offset the need to rehire even after demand has picked up.

    8. Building permits. Released by the Census Bureau, a rise in building permits can mark the beginning of a housing boom or at least a recovery. The indicator is fairly correlated to the rise in housing starts because in many cases building permits are a prerequisite for housing construction.

    9. University of Michigan index of consumer expectations. Prepared by the Conference Board, this index represents the results from a monthly survey of 5000 households to ascertain the level of consumer confidence. If the consumer feels good about his current and future economic prospects, the assumption is that he will be more likely to increase consumption and spending.

    10. Manufacturers' new orders for nondefense capital goods. Compiled by the Census Bureau, this indicator is a measure of future business investment and the assumptions of producers that they will need to ramp up production to meet unfilled orders and inventory needs.

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    Investing Side by Side with the Leading Economic Indicators

    There are many investing strategies to take advantage of the early signals of the leading economic indicators. One of the easiest strategies is to buy Exchange Traded Funds (ETFs) to ride along with the projected market trend and the rotation into and out of certain industry sectors.

    Market Play

    Generally a rise in the index or a majority of the indicators bodes well for an appreciation in the stock market. In addition, momentum traders can play the rise in the S&P index as a self-fulfilling prophesy and buy into the rally with the S&P 500 SPDR ETF (SPY).

    Sector Rotation

    • Consumer Discretionary - As consumer confidence builds, cyclical stock investors should begin rotating out of defensive stocks and consumer staples and move into a consumer discretionary ETF, such as the SPDR Consumer Discretionary Select Sector ETF (XLY), as a play on increased consumer spending.
    • Financial - As financial institutions benefit from the steeper curve, investors can benefit as well by increasing their holdings in banks through a financial sector ETF, such as the SPDR Financial Select Sector ETF (XLF).
    • Housing - With a new wave in building permits, investors can feel more confident in the return of housing profitability and begin piling into an ETF for homebuilders, e.g., the SPDR S&P Homebuilders (XHB).
    • Industrial - As new orders rise for consumer and nondefense capital goods and vendor performance time increases, industrial stocks become more appealing and investors should increase their long positions in the manufacturing sector through an ETF such as the SPDR Industrials (XLI).

    Short Opportunity

    Treasuries - Investors seeing positives in the financial indicators (interest rate spreads and M2 money supply) should consider an ETF to short long term treasuries, such as the ProShares UltraShort 20+ Year Treasury (TBT).

    As with all prognosticators, the index can also be a bad omen foretelling a slowdown in the economy and investors would be prudent to either unwind their positions to lock in profits or hedge their positions by shorting the market as well as the above-mentioned trades with inverse ETFs.