Leading Economic Index (LEI)

The Leading Economic Index (LEI) is a composite economic indicator designed to forecast the future direction of the economy. Think of it as an economic weather forecast, giving you a sense of whether sunny skies or stormy weather is on the horizon, typically over the next three to six months. Published monthly by The Conference Board, a non-profit research organization, the LEI doesn't rely on a single crystal ball. Instead, it cleverly combines ten different economic data points that tend to move up or down before the broader economy follows suit. By tracking the LEI's trend, investors and analysts can get an early warning of potential turning points in the business cycle, such as the start of a recession or the beginning of a recovery. It's one of the most widely watched barometers for economic health, providing a big-picture view that complements a detailed analysis of individual companies.

The magic of the LEI lies in its construction. It’s not just a random collection of statistics; it's a carefully curated blend of components chosen for their predictive power. These components span different sectors of the economy, from manufacturing and housing to financial markets and consumer sentiment.

For the United States, The Conference Board currently uses the following ten components to calculate the LEI. Each one acts as a scout, reporting back on a specific part of the economic landscape.

• From the Factory Floor and the Office:
  • Average weekly hours, manufacturing: Companies often cut workers' hours before they resort to layoffs, making this a sensitive early indicator of changing labor demand.
  • Initial claims for unemployment insurance: A rise in people filing for unemployment benefits is a direct signal of a weakening job market.
• From Company Order Books:
  • Manufacturers' new orders, consumer goods and materials: Fewer orders for consumer goods suggest that both businesses and consumers are tightening their belts.
  • ISM New Orders Index: This is a survey-based index from the Institute for Supply Management, reflecting the volume of new orders from manufacturers.
  • Manufacturers' new orders, nondefense capital goods excluding aircraft orders: This is a proxy for business investment. When companies order new equipment, it shows they are confident about the future.
• From the Housing and Financial Markets:
  • Building permits, new private housing units: A decline in applications to build new homes signals a slowdown in construction, a key economic driver.
  • S&P 500 Index: The stock market is famously forward-looking, with prices reflecting investors' collective expectations for future corporate profits.
  • Leading Credit Index: This proprietary index measures the health of the credit markets. Tighter credit conditions can choke off economic growth.
  • Interest rate spread: Specifically, the difference between the 10-year Treasury bond yield and the federal funds rate. A narrowing or inverted spread often precedes a recession.
• From the Consumer:
  • Average consumer expectations for business conditions: If consumers are worried about the future, they are likely to spend less, impacting the entire economy.

The Conference Board doesn't simply add these ten items up. Each component is individually weighted based on its economic significance and historical track record as a leading indicator. The final result is a single index number. What matters most is not the absolute number itself, but its direction and momentum. A series of consecutive monthly declines is a far more powerful signal than a single month's dip.

While a true value investing approach focuses on the nitty-gritty of individual businesses, ignoring the macroeconomic climate is like sailing without checking the weather. The LEI is one of the best barometers an investor has.

The LEI’s most valuable function is its ability to act as an early warning system. Historically, a significant and sustained decline in the LEI has been a very reliable predictor of an upcoming recession.

• Preparation is Key: This forewarning gives you time to prepare. It doesn't mean you should panic and sell everything. Instead, it might be a signal to review your portfolio, ensure your holdings are resilient, and perhaps build up a cash position.
• Welcome Mr. Market's Pessimism: A recession often creates the very opportunities value investors dream of. Widespread fear can cause the prices of wonderful businesses to fall far below their intrinsic value. The LEI can help you anticipate when these bargain-hunting seasons might be approaching.

Even for a bottom-up stock picker, context is king. The LEI provides crucial context for your company-specific research. If the LEI is trending sharply downward, it should prompt you to be more skeptical about rosy revenue forecasts, especially for economically sensitive (cyclical) companies like automakers, airlines, and retailers. Conversely, a rising LEI can provide a tailwind for many businesses, adding a layer of confidence to an investment thesis.

The LEI is a powerful tool, but it is not infallible.

• False Signals: It has, on occasion, predicted recessions that never arrived.
• A Guide, Not a Guru: It should never be the sole reason for an investment decision. It is one piece of a much larger puzzle.

Ultimately, the LEI is a fantastic resource for helping a value investor understand the broad economic environment. Use it to inform your judgment and manage risk, but always let your detailed analysis of a company's fundamental value be your final guide.