The Many Flaws of Leading Economic Indicators

The construction of the leading indicators has many flaws, but one of the more visible and bigger ones is the three series for new manufacturing orders. The leading index includes two dollar-based new orders series and one diffusion measure. A diffusion measure captures the breath of change, not the magnitude of change. In other words, it does not distinguish between the size of the gain or decline. Yet, dollar-based series are more important in determining economic growth since the economy runs on dollars spent.

In May, the leading index fell 0.7%. The ISM new orders index posted the most significant decline (1.4%) of any indicator, overwhelming the small gain in the other two order series (0.1% and 0.2%, respectively).

Today, the Census Bureau reported that new orders for durable goods, a dollar-based series, rose 1.8% in May. And excluding the volatile transportation sector, new orders rose 0.6%. The latest data will result in an upward revision to the dollar-based series in the leading index, but not enough to wipe out the negative contribution of the ISM New orders index.

How can anyone trust the signal from the index of leading indicators when the dollar-based new orders for durable manufactured goods (excluding transportation) posted in May, their most significant gain in over a year, and yet the sum of the three orders series in the leading index is negative because of a sharp decline in diffusion-based series? The economy runs on dollars.