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Financial market experts sometimes cite the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) as an important economic indicator, implying that it is somehow predictive of future stock market performance. According to ECRI, WLI "has an average lead of 10 months at business cycle peaks and three months at business cycle troughs..." with the most recent value summarizing any shift in overall outlook as a result of "data through the previous week." Does this indicator usefully foretell the future of equities? Using WLI readings for 3/2/01 to 5/2/08 (376 weeks) and contemporaneous weekly S&P 500 index data, we find that:
Not being ECRI subscribers, we collect WLI data from various public web sources, such as DismalScientist. Note that ECRI releases a preliminary (revised) WLI with a one-week (two-week) lag.
The following chart depicts the raw data over the entire sample period. The shapes appear generally similar, but the degree to which WLI leads or lags stock market behavior is not obvious. Because stock market behavior is an input to the WLI, two series should display some similarity.
Does the alternative visualization of a scatter plot reveal more about the relationship between WLI and stocks?
The following scatter plot relates WLI and the S&P 500 index over the entire sample period, with an exponential best-fit curve. The data indicates that the two series have a general tendency to move up and down together. However, clustering of data suggests that the relationship sometimes adjusts (switches regimes). In other words, the sensitivity of aggregate stock valuation to composite economic outlook varies discontinuously over time.
Where might the regimes be within the sample period?
The next scatter plot breaks the stocks-WLI relationship into three regimes, each with a distinct best-fit exponential curve:
While all results indicate a positive relationship between stocks and WLI, it appears that investors tend to fall relatively out of step with the economic forecast when that forecast points to recession. The number of data points on this plot likely overstates reliability, because some inputs to WLI probably do not vary weekly.
For a more sensitive view of the relationship between WLI and stocks, we compare weekly changes.
The next scatter plot relates weekly change in the S&P 500 index to weekly change in WLI over the sample period. The Pearson correlation between these two series is 0.25, and the R-squared statistic 0.06, confirming that WLI and stocks tend to move in the same direction and suggesting that weekly changes in WLI explain 6% of the variation in contemporaneous stock market behavior.
But does WLI lead the stock market, or vice versa?
The final chart shows the Pearson correlations for various WLI-stocks lead-lag scenarios. As noted above, the coincident correlation (0 weeks lead-lag) between weekly changes in WLI and weekly changes in the S&P 500 index is 0.25. Offsetting the two series such that the weekly change in WLI leads the weekly change in the stock index by 1-13 weeks produces a series of correlations near zero. Offsetting such that weekly change in the stock index leads the weekly change in WLI by 1-13 weeks produces some small positive correlations, but all weaker than the coincident correlation. The argument that stocks lead WLI is a little stronger than the argument that WLI predicts stock market behavior, especially since ECRI releases WLI preliminary/revised readings with one-week/two-week lags.
In test whether WLI exhibits any cumulative and exploitable predictive power for stocks, we relate weekly change in WLI (as revised) to the change in the S&P 500 from initial release to four weeks later, from initial release to 13 weeks later and from initial release to 26 weeks later. The Pearson correlations for these three relationships are -.03, -.05 and -.03, respectively, suggesting no exploitable relationship between weekly changes in WLI and intermediate-term stock market behavior. If anything, these results suggest a slight (untradable) tendency for reversion.
In summary, ECRI WLI movements probably coincide with or slightly trail stock market behavior, offering no trading intelligence over the short or intermediate terms. This coincident/trailing connection may tend to break down during stock market declines.
See Blog Synthesis: The Economy and the Stock Market for other research on relationships between macroeconomic indicators and stock market behavior.
