Understanding the Economic Indicators
Whether the economy is poised to take a turn or remains on course, there are special economic statistics that give us clues to what's about to happen. These clues are called leading indicators, and, as their name suggests, they take the lead in predicting which way the economy is headed. Then their cousins, coincident and lagging indicators, are used to confirm economic trends, illustrating where the economy stands now and where it's been.
Economic indicators are often tied with inflation. One reason for this is that inflation strongly influences the level of interest rates, which impact the stability of the economy. Some are also linked with production or foreign trade, both of which eventually impact consumer goods prices.
While you don't need a degree in economics to be a good investor, you need to understand how and when the economy can impact your portfolio. It makes sense for investors to have a thorough understanding of how the economy works and how economic activity is measured.
Though economists also look at coincident and lagging indicators, investors typically focus on leading indicators. For an investor, profits often come from future events and expectations. Knowing where the economy is headed can help investors (especially traders) make more profitable investment choices at the most opportune times.
Eight of the most important economic indicators are discussed here. You've probably heard of some of them, like the GDP, the consumer price index (CPI), the unemployment index, job growth, and housing starts. Others, such as the producer price index, consumer confidence index, and business inventories, are less widely known but are important all the same.
Gross Domestic Product
The GDP is the most important economic indicator published. Providing the broadest measure of economic activity, the GDP is considered the nation's report card. The four major components of the GDP are consumption, investment, government purchases, and net exports. This lagging index takes months to compute and even longer to finalize. The GDP lets us know if the economy is growing or shrinking.
Consumer Price Index
The CPI, released by the Bureau of Labor Statistics (BLS), is directly linked with the inflation rate. This index tracks retail-level price changes by comparing prices for a specific basket of goods and services to base-period prices. Unlike some other inflation measures, the CPI covers both domestically produced and imported goods. Some critics say the CPI, and therefore the measured inflation rate, is purposely understated, as the CPI is the factor used to increase Social Security payments.
The consumer confidence index monitors consumer sentiment based on monthly interviews with thousands of households. The consumer confidence index dropped drastically after the terrorist attacks of September 11, 2001. Then, for several years, the index remained fairly steady; consumers were maintaining buying patterns despite rising gasoline prices and interest rates. In fall 2008, the index dropped again, as news of home foreclosures, the credit crisis, struggling markets, and government bailouts frightened consumers into saving their money. In bad times or good, consumer confidence serves as a reflection of the nation's financial health. This index is particularly important to the financial markets during times of national crisis or panic. If consumers aren't confident, they aren't spending money, and the markets may slump further.
Second only to the GDP, the government's employment report is one of the most important economic indicators. Job growth statistics include employment information such as the length of the average workweek, hourly earnings, and the current unemployment rate. As such, this indicator sets the tone for the upcoming investing month. When job growth is up, consumers feel more at ease and tend to spend more. But when job growth shrinks, people get nervous — a strong indicator that the economy could be entering a downturn.
The unemployment index is a subset of the government's employment report. Unlike the total jobs data, which is considered a coincident indicator, the unemployment index is a lagging indicator; it changes following a change in the economy as a whole. Essentially, this makes the unemployment index less significant to investors, who are looking toward the economic future. However, several months of low unemployment rates can signal that higher inflation is right around the corner.
The housing starts indicator measures the new construction of single-family homes or buildings each month. For the purposes of this survey, each individual house and every single apartment count as one housing start; a building with 150 apartments counts as 150 housing starts.
There's an index for everything, including one that measures the leading economic indicators (called the LEI), which purports to predict future economic activity. Basically, when the LEI moves in the same direction for three consecutive months, that suggests an economic turning point. For example, three positive readings in a row would indicate an impending recovery.
Why are housing starts important? The housing industry represents more than 25 percent of total investment dollars and about 5 percent of the total economy, as per the U.S. Census Bureau. Declining housing starts indicate a slumping economy, and increases in housing activity can help turn the tide and put the economy on the road to recovery.
As a monthly running total of how well companies are selling their products, business inventories are like a big neon sign to economists and investors alike. The business inventory data are collected from three sources: the manufacturing, merchant wholesalers, and retail reports. Retail inventories are the most volatile component of inventories and can cause major swings. A sudden fall in inventories may show the onset of expansion, and a sudden accumulation of inventories may signify falling demand and hence the onset of recession.
Producer Price Index
The producer price index (PPI), also put out by the BLS, tracks wholesale price changes. It includes breakdowns on raw materials (a.k.a. commodities), intermediate goods (items that are in production), and finished goods (ready to hit the shelves). Every month, nearly 100,000 prices are collected from approximately 30,000 manufacturing and production companies and manufacturing businesses. This coincident indicator is often a good predictor of the direction of the CPI.