Leading and Lagging Indicators

What Are Indicators?  

An index is a statistic used to predict and understand financial or economic trends. 

While some indexes may seem unconventional, they can have surprising validity. For example, Leonard Lauder, chairman of Estée Lauder Cosmetics, coined the “Lipstick Index.” He asserted that increased lipstick sales signaled periods of economic distress, a claim that has proven accurate. 

However, the most closely monitored indicators are social, business, and economic statistics released by reliable sources, including various U.S. government departments. These statistics are typically based on surveys conducted regularly, often monthly, allowing results to be tracked and analyzed over time. 

The information provided by these indicators is highly influential. They play a crucial role in shaping fiscal and monetary policy, business investment decisions and strategies, and stock price valuations. 

Yield Curves  

A yield curves show interest rates on bonds of similar credit quality but with different maturity dates. The shape of the yield curve provides valuable insights into future economic conditions: 

A normal, upward-sloping curve typically indicates economic expansion. 

An inverted curve, characterized by short-term interest rates outperforming long-term interest rates, has historically been a predictor of recessions. 

However, the negative yield curves of the 2020s did not consistently conform to this historical pattern. 

New Housing Starts 

High housing starts indicate that builders are optimistic about demand for new homes in the near future. Conversely, falling housing starts indicate caution among builders, who fear constructing homes that may remain unsold. Thus, housing starts are viewed as an indicator of slowing home sales, or at least a reflection of builders’ concerns about future sales. 

Purchasing Managers’ Index (PMI)  

The Purchasing Managers’ Index (PMI) measures the health of the manufacturing and services sectors through surveys conducted among private sector companies. Its interpretation is straightforward: 

• A PMI score above 50 indicates expansion in the sector. 

• A PMI score below 50 indicates contraction. 

Money Supply  

The total amount of money circulating in an economy can be an indicator of the economy’s future strength. 

Increases in the money supply are often associated with subsequent economic growth. 

Conversely, a decline in the money supply may signal a potential economic slowdown. 

When analyzed together, these indicators can provide a more comprehensive understanding of potential economic trends. However, it is important to recognize that no single indicator is infallible. Experts differ on the degree of reliability of each of these indicators, either individually or in conjunction with others. 

Lagging Indicators  

A Lagging Indicator, while not revealing information after an event has occurred, are nonetheless valuable. They help confirm established patterns. 

The unemployment rate is a prime example of a reliable lagging indicator. If the unemployment rate rises in the previous month and the month before that, it indicates a general economic slowdown.  

A decline in employment leads to a decline in spending in the economy, suggesting the slowdown is likely to continue. 

Examples of leading and lagging indicators  

Examples of lagging indicators 

Lagging metrics provide insights into historical performance, focusing primarily on revenue-related metrics that are consistently applied across all businesses. 

For software-as-a-service (SaaS) companies, key lagging metrics include: 

• Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR): 

These metrics represent the total monthly or annual revenue generated by an organization. 

• Average Revenue Per User/Unit (ARPU): 

ARPU measures the average revenue generated by each user. 

It is calculated by dividing the total monthly or annual revenue by the number of users or subscribers during the same period. 

• Net Revenue Retention (NRR): 

Net Revenue Retention tracks the total revenue earned, lost, and retained over a specific time period. 

To calculate monthly Net Revenue Retention: 

• Start with the average monthly recurring revenue for the previous month. 

• Add revenue growth from upgrades or cross-sells. 

• Subtract revenue lost from downgrades or customer churn. 

• Divide the result by the previous month’s revenue retention rate. 

• Gross Revenue Retention (GRR): 

Analyzing GRR along with the Net Revenue Retention Rate (NRR) provides a comprehensive view of the business’s health. 

This calculation reflects the net revenue retention rate but excludes new revenue generation. 

This allows for a clear assessment of churn’s impact on revenue. 

Examples of leading indicators 

Leading Metrics for Software as a Service (SaaS) Companies 

Leading metrics provide insights into future performance and customer engagement, enabling SaaS companies to proactively improve their strategies. Key examples include: 

• Session Duration: 

• Measures the length of time customers actively use the product. 

• It is calculated by subtracting the launch time from the exit or inactivity time. 

• It indicates user engagement, and the value derived from the product. 

• Sessions per User: 

• Traces the frequency of product use over a specific period. 

• A high frequency indicates strong user engagement and strong product reliance. 

• Activation Rate: 

• Represents the percentage of users who complete a milestone. 

• It provides a more accurate measure of engagement than mere signups or downloads. 

• Important milestones can include onboarding completion or key feature utilization. 

Leading indicator: Relative Strength Index (RSI)  

The Relative Strength Index (RSI) is a technical indicator that acts as both a leading and lagging indicator. By its basic nature, it is considered a lagging indicator, as price action must precede the indicator’s directional shift. Essentially, it tracks price with a slight delay. 

However, the RSI can also act as a leading indicator. 

When the RSI reaches extreme levels, it may signal that the price has overextended and that a reversal is imminent. Due to the inherent lagging of the indicator, traders may choose to wait for the price to begin reversing before acting on the signal. As mentioned earlier, divergence can transform the RSI into a leading indicator, providing insights into potential trend exhaustion and impending reversals. 

Lagging indicator: simple moving average (SMA) 

Moving averages are classified as lagging indicators because they track price action with a delay. For example, if a price declines and then rebounds, the moving average will typically begin rising after the price has already moved.  

However, moving averages can also act as leading indicators.  

They may indicate potential support or resistance levels that the price may interact with in the future. Due to the principle of mean reversion, where price tends to return to its average after deviating, the price often returns to the moving average. 

Leading indicator: stochastic oscillator  

The stochastic indicator is primarily used to identify situations where the price may be overextended and ready to reverse. As such, it acts as a leading indicator. 

However, it’s important to realize that the stochastic indicator, in absolute terms, is a lagging indicator. This is because it compares the current closing price to the closing prices of previous price bars or candles, causing the indicator to lag slightly behind price movements. 

The stochastic indicator effectively highlights overbought and oversold areas, indicating potential buying and selling opportunities in assets that exhibit ranging or rhythmic price fluctuations. 

While the stochastic indicator can also indicate overbought and oversold levels within trends, it’s important to note that an overbought signal in an uptrend, for example, doesn’t necessarily mean a reversal is imminent. This is because the price may remain in the overbought or oversold zone for extended durations during trends.  

Furthermore, the indicator may be less effective during periods of price volatility, characterized by rapid up and down movements.  

The inherent lag of the indicator may result in entering trades just as the price is about to reverse again. 

Lagging indicator: Bollinger Bands  

Like the other indicators we’ve discussed, Bollinger Bands are inherently lagging because they only react after the price movement. However, Bollinger Bands feature a moving average and outer bands that act as leading indicators, helping to identify potential price stagnation or reversal areas. 

How to trade with leading and lagging indicators  

On our Naqdi trading platform, we offer a wide range of technical indicators that can be applied to over 15,000 assets, including shares, currencies, commodities, share baskets, ETFs, and indices. Some popular leading and lagging indicators available for trading include: 

• Bollinger Bands 

• Relative Strength Index (RSI) 

• Moving Averages (Simple and Exponential) 

• Keltner Channels 

• Moving Average Convergence Divergence (MACD) 

• Parabolic SAR 

• Average True Range (ATR) 

• Pivot Points 

We also provide a diverse selection of drawing tools that can be utilized on your trading charts, include: 

• Fibonacci retracement  

and extension tools, include: 

• regression lines  

• Gann lines 

Traders can draw trendlines, annotate price action, apply pattern detectors, and leverage more than 20 other analytical drawing tools before making trading decisions. 

*Open an account to get started and explore our award-winning platform. 

As a Straight-Through Processing (STP) broker, we guarantee that all trades are executed automatically and without human intervention, ensuring our clients receive the best available real-time prices. Our platform provides access to over 15,000 instruments across global markets, encompassing forex pairs, energies, precious metals, stocks, indices, and cryptocurrencies. 

To further enhance trading accessibility, Naqdi offers seamless trading across various platforms, whether you prefer trading on the web, your mobile device, or your desktop. 

How Reliable Are Leading Indicators for Predicting Economic Shifts?  

The yield curve’s reliability as a recession indicator varies. Although it accurately predicted all nine recessions from 1955 until the late 2010s, with only one false positive, economic shifts can alter its predictive power. Consequently, it may no longer be the reliable indicator it once was. This highlights a crucial lesson: the effectiveness of economic indicators can change over time due to structural economic transformations or policy adjustments. 

In conclusion, Understanding leading and lagging indicators is crucial for navigating the complexities of financial markets. While no single indicator guarantees perfect predictions, combining them with comprehensive analysis and an effective trading strategy enables you to make more informed decisions.  

Take advantage of the resources available on the Naqdi platform to improve your trading strategy. Start trading smarter today.