Forecasting the economy and its corresponding markets can be incredibly challenging. There are so many variables affecting the economy at any given time, and there is also no denying that even the world’s best economists are consistently wrong with their predictions.
Nevertheless, there are still quite a few ways to make the broader economy at least a little bit more predictable. Through various economic indicators, investors and consumers can predict which sorts of economic and financial changes are more likely to occur.
By using a wide range of economic indicators, it becomes a bit more attainable to make accurate predictions. In this guide, we will discuss the most important things to know about economic indicators, including the ones that might benefit you the most.
Types of Economic Indicators
Most economic indicators can be neatly placed into one of the three following categories: leading indicators, lagging indicators, and coincident indicators. To categorize any given indicator, you will need to consider the reading of the indicator relative to the trend.
- Leading Indicators: these indicators occur before economic events and are therefore frequently used to make future predictions.
- Lagging Indicators: these indicators occur after the trend and are therefore used to confirm whether or not a prediction was accurate.
- Coincident Indicators: these indicators occur during the trend. They are typically used to show where things stand in the status quo—like getting a reading from a thermometer or the odometer in your car.
Understanding how to use economic indicators will help you make more accurate predictions and adjust your strategy over time. Now, let’s look at some of the most widely used economic indicators today.
Five Key Leading Economic Indicators
As suggested, a leading economic indicator occurs before a broader trend—such as total economic growth or changes in home prices—actually happens. Below are some of the most important leading indicators.
New Residential Construction
New residential construction tracks the homebuilding activity in the country. When housing starts and housing permits increase, it typically means that, eventually, the total housing inventory will increase. It also indicates that the economy and real estate market are rallying, and developers feel confident about the economy’s future. New construction data is released every month by the U.S. Census Bureau.
New Business Applications
When the number of new business formations goes up, it indicates that the economy is in good shape and that people are willing to take risks. More business startups also suggest that the number of jobs available will likely increase soon. This data is tracked via Business Formation Statistics (BFS) and is released by the Census Bureau on a monthly basis.
Yield Curve
The yield curve illustrates the yields of debt instruments, such as bonds. It is one of the most widely examined indicators, as it reveals the expectations that major financial players have for the future. When the yield curve becomes inverted, short-term bonds are willing to pay more than longer-term bonds, meaning that investors are not optimistic about the future. Yield curve inversions have occurred before all seven recessions in the past 50 years.
Stock Market
Paying attention to changes in a company’s stock value makes it easier to forecast what its future earnings are likely to be. When a stock’s price increases, it shows that investors are confident that various components of the company—market cap, EPS, total income, etc.—are about to improve.
Consumer Confidence Index
Consumer Confidence Index reveals how the average consumer feels about the economy, regardless of whether their feelings are “warranted” or not. When consumer confidence is low, retail sales, GDP growth, home sales, and other important economic events are likely to decline in the near future.
Three Key Lagging Indicators
Lagging indicators are useful for understanding what has actually happened in the economy and whether a forecaster’s original prediction was accurate. Taking a look at lagging indicators can help you understand the bigger picture.
Gross Domestic Product (GDP)
Gross domestic product, or GDP, measures the total economic output of a country in any given year. As long as a country’s population continues to grow, it will want its GDP to increase as well. Looking at GDP makes it easy to compare the economic might of various nations.
Unemployment Rate
Low unemployment is crucial for an economy to thrive. Though a 0 percent unemployment rate might not be ideal and likely unattainable, it’s usually better for the unemployment rate to be as low as feasibly possible. When the unemployment rate shows an upward trend, this usually indicates that some market participants (people) have lost some spending power.
Inflation
Inflation illustrates how the prices of various goods and services have changed over time. One of the most common ways to measure inflation is through the Consumer Price Index (CPI), released by the Bureau of Labor Statistics every month.
A reasonable level of inflation (around or slightly below 2%) indicates that the economy is expanding at a healthy speed. However, when the cost of goods and services increases faster than average wages, the average person loses their ability to spend. The Federal Reserve pays careful attention to inflation, as high inflation often results in diminishing purchasing power and damages the economy’s long-term performance.
Economic Indicators in the Housing Market
One area where the use of economic indicators is especially essential is the housing market. Investors and ordinary homeowners alike tend to purchase their homes with the long-term goal of increasing equity. This means it will be important to forecast how the value of any prospective property is likely to change.
When the economy is moving in a positive direction—GDP is increasing, building permits are up, and the currency is strong—people are more financially secure, and the housing values will likely rise. But other indicators, such as the available housing stock, can also put upward pressure on the housing market, even when the economy isn’t thriving.
Trading Indicators
For those hoping to invest in particular stocks—rather than the broader economy—the use of trading indicators can also be very beneficial. Short-term trading indicators make it much easier for investors to predict where a stock price is most likely to move. Some of the most common trading indicators include
Moving Averages
These indicators are great for detecting major trends before they are most likely to occur. Using weighted (or exponential) moving averages gives more recent data a higher priority, which can help amplify minor changes.
Relative Strength Index (RSI)
RSI is a momentum indicator that measures whether any given security has been overbought or oversold. It uses a scale of 0 to 100, with many traders taking action once it is above 70 or below 30.
Bollinger Bands
These band indicators create a channel for where most of a stock’s price action (price movement) is most likely to occur. A trend reversal becomes more likely once the stock price breaks out of the channel. Changes in the width of Bollinger Bands can also indicate changes in volatility.
Conclusion: How to Use Economic Indicators
Making future predictions is just as much of an art as it is a science. Tracking various indicators—including both lagging and leading indicators—helps traders, investors, and homeowners better understand where the economy is headed. Revisiting their forecasting strategy and making adjustments will also be quite crucial. But with the right information and analysis, market participants of all kinds can make financially wiser decisions.
