Building Your Leading Index
In this activity, you'll create your own leading economic index by:
- Choosing weights for each indicator based on their predictive power
- Setting a threshold that signals potential recessions
- Making forecasts about future GDP growth and recession probability
Understanding the Indicators
Each indicator has been transformed into a Z-score to make them comparable. Here's how each indicator is calculated and what it tells us about the economy:
Yield Curve (10Y-2Y)
Uses 0% spread as the benchmark for inversion. This indicator captures the yield curve's shape, which flattens or inverts (goes negative) 12-18 months before recessions. When long-term rates fall below short-term rates, it signals markets anticipate economic weakness and potential central bank rate cuts.
ISM New Orders
Uses 50 as the expansion/contraction threshold. This forward-looking indicator tracks manufacturing orders, which lead production by several months. Readings below 50 indicate contracting orders, typically occurring 3-6 months before broader economic contraction affects GDP and employment.
Building Permits
Uses 0% growth as the neutral benchmark. Housing market activity typically leads the broader economy by 6-12 months because it's highly sensitive to interest rates and consumer confidence. Negative year-over-year growth in permits often signals potential economic weakness well before it appears in broader measures.
Consumer Confidence
Uses 100 as the neutral benchmark. This captures household sentiment and spending intentions, which typically lead actual consumption changes by 3-6 months. Since consumer spending accounts for roughly 70% of GDP, significant drops in confidence often precede broader economic contractions.
Manufacturing PMI
Uses 50 as the expansion/contraction threshold. This measures sentiment among manufacturing purchasing managers regarding current business conditions. As a diffusion index, readings below 50 indicate contraction across the manufacturing sector, typically leading broader economic shifts by 3-6 months.
Initial Claims
Uses the 12-month moving average as the benchmark, with negative sign to align directionality. This captures labor market deterioration at its earliest stage, as employers begin reducing workforce before broader economic contraction becomes evident. Rising claims (negative Z-score) have historically preceded recessions by 2-4 months with minimal false signals. Note: The Z-score is already inverted in the data, so negative values indicate higher claims (bad for the economy).
CLI
Uses 100 as the long-term trend benchmark. This represents the OECD's composite of multiple leading indicators already optimized for prediction. Values below 100 indicate below-trend growth, with sustained readings below 99 historically preceding recessions by 6-9 months.
S&P 500
Uses the historical average year-over-year return as the benchmark rather than 0%. This captures whether equity market performance is above or below typical growth rates. Equity markets incorporate forward-looking expectations about corporate earnings and economic conditions, with significant underperformance typically preceding economic recessions by 3-6 months.
Next Steps
Once you understand how each indicator signals potential economic changes, proceed to step 2 where you'll assign weights to create your custom index. Consider each indicator's lead time and historical accuracy when choosing weights.