Indicators are a way to measure performance. They are important in various aspects of our lives. They provide feedback on what is happening, how we can improve, and alert us to impending changes we may need to prepare for. A leading indicator is simply a warning sign of future events.
We all use leading indicators in our daily lives. A good example is the dashboard in a car. It has various gauges which alert you to a problem before it happens so that you can take action and avoid car trouble, running out of gas, etc. A traffic light is another example of a leading indicator. The light turns yellow — a warning signal — before it turns red, telling you to stop.
The primary role of leading indicators is to help alter and improve future results. In the economic arena, where the term is most commonly used, leading indicators change before the economy changes. They are early warning signs, telling us to proceed with caution.
In 1995, the Bureau of Economic Analysis, from the Department of Commerce, created a private, non-governmental organization, the Conference Board, to determine a monthly leading index. The index, called the Leading Indicator Index, is calculated based on ten different variables. The leading indicators used to calculate the index include things such as the level of the S&P 500 index, the value of the inflation-adjusted money supply, and the average number of new applications for unemployment insurance filed in the previous month.
There are many factors in the manufacturing industry which are taken into account when calculating the Leading Indicator Index. The amount of new orders for manufacturing goods and materials, as well as the speed with which vendors deliver the new merchandise are both considered. Also figured into the equation is the average weekly hours that manufacturing employees work. Last, but certainly not least, consumer sentiment and the amount of new residential building permits are considered.
Historically, these ten variables have turned downward before a recession. However, no system used for predicting the future is perfect. One problem with the index of leading indicators is that the delay between the signal of a possible recession and the actual recession fluctuates. The index has also fallen on occasion without being followed by a recession.
Regardless of their accuracy, leading indicators are helpful because they give an early warning of impending trouble. It is an indication that we need to take a closer look, examine what is happening, evaluate the accuracy of the information, and make any necessary adjustments for the future.