Question

b) There has been considerable growth in recent years in the use of economic analysis in investment management. Further significant expansion may lie ahead as financial analysts develop greater skills in economic analysis and these analyses are integrated more into the investment decision-making process. The following questions address the use of economic analysis in the investment decision-making process: (1) Differentiate among leading, lagging, and coincident indicators of economic activity, and give an example of each based on the part a). (2) Indicate whether the leading indicators are useful for achieving above-average investment results in automobile Industry. Justify your conclusion.

Answer 1

Economists and investors are constantly watching for signs of what's immediately ahead for the markets and for the larger economy.

• Leading indicators are considered to point toward future events.
• Lagging indicators are seen as confirming a pattern that is in progress.
• Coincident indicators occur in real-time and clarify the state of the economy.

Leading Indicators

Leading indicators are a heads-up for economists and investors who hope to anticipate trends.

Bond yields are thought to be a good leading indicator of the stock market because bond traders anticipate and speculate about trends

New housing starts also are a leading indicator. If housing starts rise, it means builders are optimistic about the demand in the near future for newly constructed homes. If housing starts fall, builders are getting cautious. That's a sign that home sales are slowing, or at least that builders fear they soon will.

The overall money supply, which is tracked by the federal government, is a more complex leading indicator. Generally, if there is plenty of money out there, in consumers' pockets, in bank accounts, and in bank vaults ready to be invested in business expansion, it's a signal that the economy will be strong.

Lagging Indicators

Lagging indicators can only be known after the event, but that doesn't make them useless. They can clarify and confirm a pattern that is occurring over time.

The unemployment rate is one of the most reliable lagging indicators. If the unemployment rate rose last month and the month before, it indicates that the overall economy has been doing poorly and may well continue to do poorly.

The Consumer Price Index (CPI), which measures changes in the inflation rate, is another closely watched lagging indicator. There are few events that cause more economic ripple effects than price increases. Both the overall number and prices in key industries like fuel or medical costs are of interest.

Coincident Indicators

Coincident indicators are analyzed and used as they occur. These are key numbers that have a substantial impact on the overall economy.

Personal income is a coincident indicator of economic health. Higher personal income numbers coincide with a stronger economy. Lower personal income numbers mean the economy is struggling.

The gross domestic product (GDP) of an economy is also a coincident indicator.

2.Leading indicators have historically been a good tool for anticipating the economy.Investment managers should be aware of this information and, where possible,investment decisions might reflect projected trends. However, these indicators are byno means infallible. They often generate false signals. A downturn in leadingindicators might precede only a retardation of growth rather than a full blownrecession if the downturn is shallow or brief. One of the most consistent leadingindicators is stock prices represented by the S&P 500 Stock Composite Index. Thus,we are dealing with indicators that are roughly coincident with the most significant determinant of stock returns and price changes.