Often it is said that stock market indices are the barometers of a country’s economy. There exists a strong link between the overall economic environment in a country and the performance of its stock markets. Stock markets reflect what is expected to go on in an economy because the value of a share is determined by its expected cash flows and its future required rate of return, and both of these factors are influenced by its expected aggregate economic environment. Let us discuss certain key economic indicators.
These are the indicators which usually reach peaks or troughs before corresponding peaks or troughs in aggregate economic activity. Leading indicator approach for analysis of business cycles and growth cycles is used by many countries. We have leading indicators proposed by National Bureau of Economic Research (NBER), Organisation for Economic Co-operation and Development (OECD) and World Bank. But these indicators are not directly applicable to the Indian context. Accordingly, Reserve Bank of India and National Bureau of Economic Research came out with some appropriate indicators.
Some of the leading indicators are Index of Industrial Production (IIP) growth cycle, manufacturing activity, inventory level, retail sales, building permits, level of new business start-ups, etc. Among all the indicators it is empirically proved that the IIP growth cycle has a forecast horizon of four months. In terms of back performance, the IIP growth cycle has been able to track all the turning points in advance.
These are the indicators which usually change after the economy expands or contracts in the aggregate economy. Typically, lagging indicators are output based. They are generally easy to observe and measure but difficult to improvise or influence, whereas leading indicators are input oriented and easy to influence. Lagging indicators are those indicators such as change in GDP rate, interest rate, inflation rate, unemployment rate, currency strength, corporate profit, balance of trade, etc.
These are the important indicators such as employment, real earnings, average weekly hours worked in manufacturing, etc. , as they depict the current economic activity in an economy. To track the movement of the current economic condition of the Indian economy, two Composite Index of Coincidental Indicators (CICI) have been constructed for the two-reference series, viz., the monthly IIP and quarterly GDP growth rate cycles. The CICI for the monthly IIP growth rate cycle has been constructed based on three economic indicators, viz., IIP—Intermediate Goods, IIP—Consumer Durables and Bombay Stock Price Index—30 script. In terms of back performance, the CICI has been able to track all the turning points synchronically with the reference series to a greater extent.
Which one to use?
Both lagging and leading indicators are critical. Using only lagging indicators is like trying to drive your car using only the rear view or side mirrors. It is great for backing out of the driveway or parking your car. Moving forward is difficult, if not impossible. Some of the most important information you need to invest, avoid peril and successfully navigate the financial path are things you can see before you are there. Leading indicators let you know what to expect. They help with forecasting and predicting where your economy
is going and protect you from falling off the cliff.
As the health of the economy is intimately connected to various indicators as discussed above it is essential to accurately characterise the state of the economy. You must rely on your own analysis or perhaps the analysis of others without a pre-conceived idea. By considering the entire picture, you can thereby make better decisions regarding your overall financial plan and investments.
P Saravanan is associate professor of finance & accounting, IIM Shillong