Lead, Lag and Coincident Indicators

In the era of COVID-19, and the financial woes it has created, I often get asked, “Why is the stock market holding up so well when the economy appears to be struggling?”

To understand why the markets react — or don’t — to certain outside factors, it’s always good to keep in mind that the stock market is not the economy. To understand this, we’ll need to dust off those economic textbooks of yesteryear and turn to the chapter on “lead, lag, and coincident indicators.”

“Lead indicators” are factors that are used to anticipate what may happen 6-9 months in the future. Think of the stock market as the foremost lead indicator. Another “lead economic indicator” is building permits. When there is an increase in building permits, it lets us know that developers are bullish about future home sales prospects. If building permits are down, it tells investors that builders may be concerned about interest rates and consumer confidence.

Now, imagine that the stock prices today are anticipating where the economy will be in 6-9 months. Is it correct? Despite what some may claim, no one knows for sure. Although helpful in general, lead indicators should never be seen as infallible. Abrupt and unexpected changes will prompt lead indicators to rapidly recalibrate their expectations for the future. Look no further than when COVID-19 grabbed the headlines in early March, which ended the stock market’s 11-year bull market.

Alternatively, “coincident indicators” attempt to show the state of the economy right now. For example, gasoline deliveries are currently trending higher, consumer confidence appears to have stabilized, and airlines are seeing more bookings. Even the supply of toilet paper seems less of a concern these days! This may hint at higher consumer confidence at present.

Finally, “lag indicators” provide insight into past economic data. They may confirm long-term trends, but they are not very good at forecasting. The consumer price index is a historically classic example of a lag indicator. It tells us what inflation was, but doesn’t provide much insight about the future.

In general, when trying to evaluate why the markets are behaving a certain way, it may be best to gather as much data as possible. Economic indicators can help provide context for what can often seem counter intuitive behavior, especially in the face of intense global disruption.

Let me know if you’d like to chat about the economy or any other topics you’re pondering. I’m always here to help.