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The early bird catches the worm: how traders use leading indicators

JUST when we thought those fragile green shoots of recovery in the developed world were starting to flower, a recent swath of disappointing data has dashed traders’ hopes of stronger growth. Besides the ongoing sovereign debt crisis in the Eurozone, the recovery in the US jobs market has been much weaker than expected and Finland is now officially suffering a double-dip recession. And to top it all off, the Organisation for Economic Cooperation and Development (OECD) reported on Friday that its composite leading indicator for 29 developed countries showed a slower pace of growth for the ninth consecutive month.

So what are leading economic indicators and how much importance should traders be giving the blizzard of economic data? Leading indicators, such as those compiled by the OECD, are designed to provide early signals of turning points between expansions and slowdowns of economic activity. Some closely watched leading indicators include the purchasing managers’ indices, consumer sentiment and the number of new houses under construction.

Alastair McCaig, head of investment management at WorldSpreads, says that traders would be naive to ignore economic data releases given that markets will always be trying to factor in new information as and when it arrives. These indicators can be important for traders because the stock market tends to lead the economic cycle by about three months or so and it is forward-looking. That is, investors base their decisions on what they expect will happen rather than what has happened and market valuations reflect expected future earnings.

RBC Asset Management says that the lag between the stock market cycle and the economic cycle creates a challenge for investors, as strong emotions at both peaks and troughs push people into buying high and selling low – exactly the opposite of what they should be doing.

Therefore there is little point basing your trading decisions on highly positive economic data if the leading indicators are suggesting that a double-dip is just round the corner. The chances are you will find yourself on the wrong side of the trade.

However, some composite leading indicators are often not published early enough for traders to take advantage. For example, the OECD’s indicator for April, which pointed to a slowdown in economic expansion not just in the developed world but also in emerging market powerhouses such as China and Brazil, was only published last Friday. Selling in early May in anticipation of a slowdown would have paid off rather nicely had you been aware that leading indicators were showing a loss of momentum.

Investors looking for more timely leading indicators of economic activity may therefore prefer to look at data releases such as the purchasing managers’ indices and other industry surveys. These were already signalling a slowdown in activity and pointing to waning confidence in late April. It is also worth paying attention to economic figures if they diverge substantially from what was expected as this can cause the market to move.

Given that the stock market runs ahead of the economic cycle, so should you.