Leading vs. Lagging Indicators – What’s the Difference?
The stock market is generally considered to be an unpredictable system dictated by the law of supply and demand. Although you’ll never be 100% accurate when you invest, there are several tools you can use to improve the predictability of the market as you work to meet your investment initiatives.
Typically, well-researched investment decisions based on a mix of fundamental and technical metrics result in the most impressive gains. Another key factor is timing. That’s where leading and lagging indicators come in.
But what’s the difference between a lagging and leading indicator, how do the two help you become a more successful investor, and how do you use them in your day-to-day market activities?
Leading vs. Lagging Indicators — What’s the Difference?
There are several different types of indicators investors use to understand the market and improve their chances of positive investing outcomes. These indicators are divided into leading and lagging indicators based on what kind of information they interpret and whether they look forward or backward.
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A leading indicator, also commonly called a leading metric, is an indicator that’s used to make predictions. Investors and traders use these indicators to determine if the values of assets are likely to rise or fall in the near future.
Because leading indicators attempt to predict the future, they are the less accurate of the two styles of indicators. As a result, it’s imperative to use multiple measurements to confirm findings from leading indicators.
There are two different types of leading indicators:
- Leading Technical Indicators. Leading technical indicators use historical price data to predict future price trends.
- Leading Economic Indicators. Leading economic indicators use macroeconomic data in an attempt to predict future economic activity. Although traders don’t typically use economic indicators, they’re crucial for long-term fundamental investors.
As mentioned above, there are leading technical and economic indicators. Here are a couple of examples of each.
Examples of Technical Leading Indicators
Technical leading indicators produce signals that tell investors what an asset’s price is likely to do in the near future. Again, they’re not 100% accurate, but using multiple indicators together can help you confirm your readings. Here are a couple of popular leading technical indicators:
- Relative Strength Index (RSI). The relative strength index (RSI) is both a leading and lagging technical indicator that defines the strength of a trend and signals potential reversals. As a leading indicator, you can use RSI to signal when fast-moving securities become overbought or oversold and are about to reverse direction.
- Stochastic Oscillator. The stochastic oscillator is another technical indicator that you can use as either a leading or a lagging indicator. As a leading indicator, you can use it to highlight overextensions in price, signaling potential reversals in the future.
- On-Balance Volume. On-balance volume measures changes in a stock’s trading volume to predict price changes. Increasing selling volume is a signal that prices could drop significantly while increasing buying volume suggests prices might rise.
Examples of Economic Leading Indicators
Economic leading indicators use current information to predict the future direction of the economy. Here are a couple of common examples:
- Purchasing Managers’ Index (PMI). The purchasing manager’s index (PMI) is a survey of purchasing managers at businesses across the country. It’s a leading economic indicator that measures the sentiment of managers who purchase materials for their companies. When businesses are purchasing lots of raw materials, it tends to mean healthy manufacturing output and economic activity ahead.
- Consumer Confidence Index. The Consumer Confidence Index is a survey of consumers across the country to determine how confident they are in the state of the economy. Consumers spend more money when they’re more confident. Strength in this index points to positive economic growth ahead, while weakness could be a sign of trouble.
Lagging indicators look back at historical data to help spot trends. Investors use lagging indicators, or lagging metrics, to confirm the direction and veracity of trends. These indicators are also commonly used before you act to confirm the findings of leading indicators and avoid any false signals.
Like leading indicators, lagging indicators can encompass technical or economic data. Technical lagging indicators analyze historical price data to confirm the direction and veracity of trends in the market or in a specific financial asset, while economic lagging indicators use historical economic data to give a reading on recent economic movement.
Examples of Technical Lagging Indicators
Technical lagging indicators all have one thing in common; they use historical data to help investors confirm trends. Some of the best examples of these indicators include:
- Moving Averages. Moving averages are averages of price data over a predetermined period of time plotted on a stock chart. Each day, the new closing price is added to the average and the oldest is removed. This technical indicator provides a visual look at past price movements while smoothing out the volatility of the market to make it easy to determine the direction and strength of a trend.
- Bollinger Bands. Bollinger Bands are a technical indicator that takes the shape of an upper band, lower band, and signal line plotted on a stock chart. Investors look for relationships between these bands to determine the strength of a trend. Moreover, investors and traders look for price crossovers in relation to the upper or lower bands to validate the strongest trends.
Examples of Economic Lagging Indicators
Economic lagging indicators review recent economic data to give us a reading of the state of the economy. Here are a pair of familiar lagging economic indicators:
- Gross Domestic Product (GDP). GDP measures the entire value of production across a country. That production must take place before it can be measured. As such GDP is a lagging economic indicator used to confirm the strength, or lack thereof, of a country’s economy.
- Unemployment Rate. The unemployment rate is a lagging economic indicator because it is compiled using data from unemployment assistance applications over a previous period of time. When unemployment levels are low, the economy is believed to be in good shape. Conversely, when unemployment levels rise, they raise questions about economic sustainability.
How to Use Leading & Lagging Indicators
When you use technical indicators, whether lagging or leading, it’s important to keep two things in mind:
- There’s No Way to Predict the Future. Leading indicators aren’t a crystal ball. They attempt to predict future events, and for that reason they are wrong on a regular basis.
- History Doesn’t Always Repeat Itself. Lagging indicators are used based on the premise that history repeats itself in financial markets and economic developments, but that’s not always the case. Although lagging indicators are historically more accurate than leading indicators, they’re not perfect either.
You may be wondering, “what’s the point of using these tools if they’re not accurate?”
None of these tools are perfect, but you can increase the accuracy of lagging and leading indicators by using them together. The combination of leading and lagging indicators gives you the ability to confirm clear signals or weed out false signals.
For example, say you’re using the stochastic oscillator as a leading indicator to analyze a stock you own. The indicator has a reading of 85, which suggests the stock is possibly overbought and a downward reversal may be on the horizon. Should you sell it?
If you’re using the stochastic oscillator alone, you may decide to exit your position to avoid a reversal.
However, if you decide to use multiple indicators together, you might start by checking the RSI too. Say you find the reading is 65, which puts it well below oversold territory and instead points to a strong upward trend.
At this point, you have two conflicting indicators telling you to do different stories. Your best next move doesn’t seem so clear.
To break the tie, you might look at the simple moving average (SMA) for the stock. Perhaps once the volatility is shed from the stock chart, you’ll see a clear, well-defined trend higher. Now you’d have two indicators suggesting the uptrend will continue and only one suggesting a reversal is on the horizon.
If you would have gone with your first signal, you would have sold your position, but by bringing in lagging indicators to verify your findings, you realize that holding is your best option.
Leading and lagging indicators are tools that you should keep in your toolbox whether you’re a short-term trader or a long-term investor. These tools make it easier to define trends and predict future price movements, but they’re not perfect. You can improve your outcomes by using multiple indicators in conjunction with one another, ensuring a healthy mix of both leading and lagging data.
However, improved outcomes don’t mean risk-free investing. No indicator or combination of indicators is perfect, and there’s always the potential for loss. Always be sure to do your research and practice sound risk management as you invest.