Understanding the Past, Predicting the Future
January 30, 2023 | Anthony Conte, MSFS, CEPA, CFP®
There are indicators that we can simply ignore, the blinking LED clock on the microwave from the last power outage, and others that we would do well to notice and act upon, like the check engine light on your 15-year-old Honda.
I’m still torn on how important it is to actually address the low tire light when the pressure in one tire is only a few psi different than the others, but I’m not a car guy. Actually, you might not want to take my advice on this, I did overlook changing the oil in my first car, a 1990 Ford Escort, until it started clacking loudly and smoke plumed from the hood.
In the world of finance and economics, investing with an eye toward future economic conditions, leading indicators can be a helpful guide. While never fail-proof as a portent of things to come, a number of leading indicators pointing toward worsening economic conditions can help to better inform a long-term investment strategy and sector specific allocations.
Lagging indicators, on the other hand, help us to understand where the economy has been. These indicators tend to be easy to identify and capture, but they inherently lack much predictive power.
Turn on any news station during fraught economic times, and you will surely hear mention of at least two of the lagging indicators below.
It is important to note that even though lagging indicators tend not to help us in any predictive way, they can help us better understand the macro-economic view and to identify long-term trends.
The repetition of trends and extrapolation of various patterns in the economy can help us to use history as our guide with an eye toward the future. It’s not exactly predictive, but helpful, nonetheless.
Gross Domestic Product measures the economic output generated within the borders of a country, and it is an indication of the overall health of an economy. When GDP increases, it is widely seen as strength in the economy, whereas a slide in GDP suggests that growth has slowed.
The much-discussed rule of thumb for recessions suggests that two consecutive quarters of negative GDP growth mean that a recession has occurred or is occurring. It is worth noting that this rule of thumb is only a fraction of the calculation that is made by the National Bureau of Economic Research in establishing whether or not we have been in recession.
GDP, as with any indicator, is imperfect. It can be disproportionately impacted by excessive government spending and programs like ‘quantitative easing’, thus shifting the measure artificially.
As indicators go, corporate profits are an oft-cited, oft-misunderstood metric.
Corporate profitability provides a measure of the financial health of corporations and is a measure of an economy’s economic performance.
Rising corporate profits can be interpreted to mean that we might expect a rise in GDP as well, given that the two are often correlated. And when corporate profits have risen, it isn’t uncommon to see a positive impact on stock market valuations, all of which seems to suggest that rising corporate profits are good for the broader economy.
While this is often true, rising corporate profits during times of higher-than-average inflation may not help us to accurately gauge the true impact on the economy because a dollar in profit even a quarter prior may not be as impactful to the company or the stock of the company when that dollar is valued at less than it had been.
The Great Recession (2007 – 2009) saw corporate profits jump during times that weren’t inflationary, but the surge in profits was correlated, in that instance, with a loss of jobs domestically because companies were leveraging opportunities to outsource and downsize. Clearly this did not have a positive impact on the domestic jobs markets, and ultimately, this indicator suggested the economy had been stronger than it was.
This is a measure of the percentage of the labor force that is looking for work, and an unemployment rate between 3% and 5% is considered healthy for the economy.
This indicator can have counterintuitive impacts on the stock market in our topsy-turvy economy.
Where we might reasonably expect that higher unemployment rates would leave consumers with less money to spend and negatively impact overall spending, of late, leading indicators that suggest that we might be in for higher unemployment rates moving forward have been remarkably positive for the stock market.
One explanation for this is that the stock market could be pricing in a less aggressive Federal Reserve stance on future rate hikes, and if that comes to fruition it can ease some of the pressures on stock market valuations. But that is a big ‘if’ when the Fed has made clear its intentions to end the year with higher rates than it currently targets.
Anyone who has spent any time reading about the economy in the last year is likely familiar with the Consumer Price Index.
The CPI measures the change in price of a basket of goods over various periods to better understand whether or not costs are increasing (inflation) or decreasing (deflation). Common essential goods and services included in the calculation are vehicles, professional services, clothing, transportation and much more.
A certain amount of inflationary pressures are healthy for an economy to encourage investment given that idle cash will simply lose value if inflation has taken hold. Additionally, inflationary pressures protect us from the deleterious impacts of deflation, which can lead to economic depressions.
As a lagging indicator, the CPI tells us what prices have done, but it doesn’t tell us where they are headed next.
After having spent some time considering some of the more popular lagging indicators, I will spend some time helping you to predict the future with a primer on some of the more popular leading indicators.
Read the article in Central Penn Business Journal here.
Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker/dealer, member FINRA/SIPC. Advisory services offered through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Conte Wealth Advisors, Central Penn Business Journal, and Cambridge are not affiliated.