Most economists talk about where the economy is headed – it’s what they do. But in case you haven’t noticed, many of their predictions are wrong. For example, Ben Bernanke (head of the Federal Reserve) made a prediction in 2007 that the United States was not headed into a recession. He further claimed that the stock and housing markets would be as strong as ever. As we know now, he was wrong.
Because the pundits’ predictions are often unreliable – purposefully so or not – it is important to develop your own understanding of the economy and the factors shaping it. Paying attention to economic indicators can give you an idea of where the economy is headed so you can plan your finances and even your career accordingly.
There are two types of indicators you need to be aware of:
- Leading indicators often change prior to large economic adjustments and, as such, can be used to predict future trends.
- Lagging indicators, however, reflect the economy’s historical performance and changes to these are only identifiable after an economic trend or pattern has already been established.
Because leading indicators have the potential to forecast where an economy is headed, fiscal policymakers and governments make use of them to implement or alter programs in order to ward off a recession or other negative economic events. The top leading indicators follow below:
1. Stock Market
Though the stock market is not the most important indicator, it’s the one that most people look to first. Because stock prices are based in part on what companies are expected to earn, the market can indicate the economy’s direction if earnings estimates are accurate.
For example, a strong market may suggest that earnings estimates are up and therefore that the overall economy is preparing to thrive. Conversely, a down market may indicate that company earnings are expected to decrease and that the economy is headed toward a recession.
However, there are inherent flaws to relying on the stock market as a leading indicator. First, earnings estimates can be wrong. Second, the stock market is vulnerable to manipulation. For example, the government and Federal Reserve have used quantitative easing, federal stimulus money, and other strategies to keep markets high in order to keep the public from panicking in the event of an economic crisis.
Moreover, Wall Street traders and corporations can manipulate numbers to inflate stocks via high-volume trades, complex financial derivative strategies, and creative accounting principles (legal and illegal). Since individual stocks and the overall market can be manipulated as such, a stock or index price is not necessarily a reflection of its true underlying strength or value.
Finally, the stock market is also susceptible to the creation of “bubbles,” which may give a false positive regarding the market’s direction. Market bubbles are created when investors ignore underlying economic indicators, and mere exuberance leads to unsupported increases in price levels. This can create a “perfect storm” for a market correction, which we saw when the market crashed in 2008 as a result of overvalued subprime loans and credit default swaps.