The economy is a hard beast to tame, and no one indicator is able to fully encapsulate what it is doing. That is why we at Valens like to look at the economy from as many points of view as possible.
Today, we will review how a mosaic approach using both leading and lagging indicators can help see through the macro noise.
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Currently, it is difficult to quantify how fast economies are opening back up. That is why people are using new indicators to gauge economic activity. One interesting indicator we saw recently was in the Economist.
They had a fascinating graphic highlighting how pollution levels have changed in large cities around the world. The graphic includes New York City, London, Delhi, Paris, and a handful of other large urban areas.
These cities all saw a tremendous drop in pollution as the quarantine began in the middle of March and economic activity slowed. Most of the cities’ pollution levels began to rise after reaching troughs in April, but the rise wasn’t consistent across cities, or in its trend of returning to pre-quarantine levels.
Normally, pollution level movements are likely to be consistent or have specific times of inflection throughout the year, but this was unique.
In the context of the pandemic, the rising trend of pollution levels since March in the chart can tell us how close things are to being back to normal. Pollution returns signal a recovery in factory output, overall transportation levels, power plants, and general productivity.
That data gives good and concerning economic signals.
Paris and Bangalore have only seen emissions come back to 80% and 70% of pre-pandemic levels, respectively. On the other hand, Rome, London, and Delhi are all near or at pre-pandemic levels. Clearly those cities are running ahead of Paris and Bangalore.
That being said, air pollution is a lagging indicator for investors to monitor for economic activity, not a leading one.
However, it cannot be looked at alone, it needs to be seen with other lagging and leading indicators in order to get a complete picture.
In any field, leading indicators are data points that can tell that something is “about to happen.” Lagging indicators mean something “has happened.”
When you are making pasta, bubbling water is a leading indicator that your pasta is about to be cooked. The pasta sticking to the wall is a lagging indicator that your pasta has been cooked.
Unless you like it the proper way, al dente, in which case it sticking to the wall means your pasta is overcooked, and you’re going to need to start over.
In terms of macroeconomics, leading indicators help predict where the economy is heading. Some examples include building permits, inventory levels, and even the stock market itself.
The stock market is a leading indicator because it is focused on future outcomes and cash flows. Investors are attempting to price in potential risks or turnarounds before they occur. Although a tremendous aggregator of data, the stock market is not able to always tell the future, but it gives a good window into where the wisdom of the crowds think earnings growth and economic activity is heading.
Leading indicators provide data points on what people are expecting to happen. While some indicators are more consistent than others in terms of accuracy, used in aggregate, these metrics can help inform where the market is going. That being said, leading indicators do not always paint a complete and accurate picture of where the economy is heading.
Sometimes building permits can be cancelled, inventory levels actually get worked down because demand accelerated, or the stock market in aggregate completely missed something, like in January and early February this year with the pandemic.
That is why lagging indicators, like air pollution levels, are important. Some people tend to shrug these off because the insights they provide are for trends that have passed. However, lagging indicators are necessary to confirm a trend is occurring. Not all of them take quarters to come through, some can tell very quickly if something is happening, confirming what the lagging indicators signal could be happening.
Examples of these indicators are inflation, trade balances, and loans outstanding.
There are many economic indicators in the market published from both private companies and the government. Some indicators, especially leading ones, have the ability to give false flags. That is why it is important to build a mosaic, looking at multiple leading and lagging indicators to obtain a full grasp on the economy.
That is especially important in a period of significant volatility, as we’ve experienced the past 6+ months, and especially with so much uncertainty in the midst of the recent pullback since early September.
It is impossible to have total confidence about the future until many leading indicators are all pointing in the same direction, so it’s important to look at them in their totality. Then, it is necessary to see their confirmation looking at multiple lagging indicators.
The imperfect record of individual economic indicators is why at Valens, we never hang our hat on any singular metric when we look at the macroeconomic environment. It is why each Monday we cover a different indicator we think is important for economic activity, so we can aggregate them over time and get confidence in times of panic or euphoria if things are reasonable. It’s also why we produce our Market Phase Cycle report each month for clients, reviewing all those insights.
For example, when looking at the credit environment, we have mentioned consumer credit, C&I loans, and our aggregate Intrinsic credit default swap index. All of them tell us that while the current pullback is unpleasant, we don’t have to worry about a collapse of credit for corporates or consumers that could lead to a significant sell-off in the near-term.
While discussing corporate valuations, we have researched inflation and our own aggregate Uniform value-to-asset (V/A’) metric. These point to signals that say that while credit doesn’t signal reasons for a massive pullback, valuations have gotten somewhat expensive. That means this pullback is healthy, but also the market doesn’t need to immediately go higher once we find a base.
Our analytics on management sentiment and corporate profitability signal reasons for confidence on corporate earnings trends. It may also be flashing signs that growth, which management teams had been bullish about in May-July, may be slowing, also putting a pause on appreciation.
Using all of these markers and more allow investors to have a holistic view on the economy. The economy is driven by innumerable factors, and requires a diverse viewpoint to understand. To try to follow the economy and predict it accurately, it is vital to always look at multiple indicators.
The current pullback may have some investors concerned, but when we look at the market holistically, it just looks like an opportunity to dollar cost average lower, because we can have confidence that a credit collapse is unlikely, and therefore a sharp bear market sell-off is too.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research