No matter what you do, having the right tools for the job makes the process far more efficient. Can you imagine a roofer trying to hammer shingles into a roof with a screwdriver? In the stock market, tools that help you analyze trends and pinpoint the most advantageous times to enter and exit trades are just as important.
Leading indicators are one type of tool you should have in your toolbox as you work on Wall Street, whether you’re a trader or a long-term investor. These indicators produce signals that help you determine the future direction of financial assets.
What Is a Leading Indicator in the Stock Market?
Leading indicators are tools that use historical data in an attempt to predict future conditions. These include leading economic indicators that suggest trends in economic activity, technical indicators that assess and signal trends in stocks and other assets, and key performance indicators (KPIs) specific to a business.
Investors use leading indicators to define trends and determine whether they are likely to continue, pinpoint likely turning points for well-timed entries and exits, and determine the state of the overall economy and financial markets.
Leading technical indicators in the stock market use historical stock price data to find patterns and predict future movements in stock prices. They may also be used for currencies and various other financial assets.
How Leading Indicators Work
Leading indicators work by assessing historical data to determine future price movements.
This is often done by simply averaging asset prices over a set number of trading sessions, known as the moving average. In some cases, the relationships between multiple moving averages set at different time frames give clues as to the future direction of a stock. In others, the relationship between a moving average and a security’s price or standard deviations of moving averages give you clues as to how high or low a stock price is likely to go.
The basic premise is that price action in the stock market is directly related to investor sentiment. When investors think a stock is oversold, they tend to buy it. If it’s overbought, they tend to sell it. So, when you use historical data to find stocks in these categories, you can produce meaningful profits by trading based on what leading indicators tell you.
Types of Leading Indicators
Investors and traders alike use several types of leading indicators to determine the future direction of stocks and other financial instruments. Some of the most popular examples of the different types of indicators are below.
Relative Strength Index (RSI)
The relative strength index (RSI) is a good leading indicator for beginners because it’s easy to read. The RSI compares the strength of price movements on positive days to that of negative days. These readings can tell you whether a stock is trending more strongly up or down and likely to tilt in that direction in the near future.
Like all leading metrics, it’s important to couple the RSI with other metrics to avoid any potential false signals.
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD) is a momentum oscillator that uses historical data to show the relationship between two moving averages of an asset’s price as well as a MACD line and a signal line. Investors and traders look for crossovers, divergences, and patterns in the histogram to determine the future direction of an asset’s price.
The stochastic oscillator compares the most recent closing price of a financial instrument to a high-low range of prices over a predetermined period of time.
Like the RSI, the stochastic oscillator produces a reading ranging between 0 and 100. When the reading is 20 or lower, investors see it as a sign that the asset is oversold and likely to make a move higher in the near term. Conversely, when the stochastic oscillator reading is above 80, investors consider the stock overbought and brace for a downward reversal.
Leading vs. Lagging Indicators
There are several different types of indicators to choose from as you work in financial markets, but they all fall into one of two categories: leading indicators and lagging indicators.
Leading indicators use historical data to identify trends and attempt to predict future price movements in the market. Lagging indicators use historical data (lagging metrics) to confirm trends and outline the momentum, or veracity, of those trends.
Some indicators can be both leading and lagging; this is true for most leading technical indicators. For example, the RSI can be used as a lagging indicator to define a trend and determine its momentum. When the indicator moves into overbought or oversold conditions, it acts as a leading indicator, predicting a reversal in the price of the asset.
Pros & Cons of Leading Indicators
Any tool you use as you invest, trade, or otherwise work in financial markets comes with pros and cons. Leading indicators are no different.
Pros of Leading Indicators
Leading indicators are popular tools among investors and traders alike. They earned their popularity by giving market participants a leg up as they assess opportunities. Some of the biggest advantages to using leading indicators include:
- Easy-to-Read Trading Signals. Most trading strategies use a mix of leading indicators to produce trading signals that are easy to read in a fast-paced environment. These signals are often easy to spot at a glance, typically by reading a number or looking for points at which two lines cross.
- Long-Term Entrances and Exits. Long-term investors typically use leading indicators to determine the best times to buy the stocks they’re interested in adding to their portfolio and the best times to sell the duds.
- Improved Trade Timing. Leading indicators help you determine when to buy and sell stocks by showing you if the stock is likely to rise or fall in value in the near term.
- Higher Returns. Although leading indicators come with a learning curve, once you’re proficient in using them, they have the potential to substantially improve your market profitability.
Cons of Leading Indicators
There are plenty of reasons to use leading indicators, but it’s important to understand their drawbacks too. Some of the most significant limitations include:
- False Signals. Leading indicators attempt to predict the future, and no indicator is right 100% of the time. That means you’ll encounter false signals from time to time, where a leading indicator tells you it’s time to buy or sell and turns out to be flat out wrong.
- Not for Use Alone. You should use leading indicators in conjunction with a mix of other leading and lagging metrics to reduce your exposure to potential false signals. The more indicators that corroborate your signals, the more confidence you can have in them.
- Some Technical Knowledge Required. There’s a slight learning curve for beginners because many indicators in this category require some knowledge of technical analysis.
Should You Use Leading Indicators?
Whether you’re trading or investing, leading indicators should have a space in your toolbox. Sure, these indicators are known for producing false signals, but when you use a few indicators together, they have the potential to improve your overall performance in the market.
Leading Indicator FAQs
Any indicator of economic or market performance is somewhat complex by nature. Leading indicators are no different. Find the answers to some of the most frequently asked questions about leading indicators below.
What Are the Best Leading Indicators?
The best indicators for you depend on your strategy and personal preferences. The most popular leading indicators are the RSI, MACD, stochastic oscillator, Consumer Confidence Index, CPI, PMI, revenue growth, earnings growth, and guidance.
Why Are Leading Indicators Important?
Due diligence is the basis for any solid investment or trading decision. Investors and traders use leading indicators to assess the overall market as well as specific financial assets as they research potentially profitable opportunities.
Do Leading Indicators Always Work?
No. Leading indicators don’t always work. They’re notorious for producing false signals. That’s why it’s crucial that you use multiple leading and lagging indicators; each indicator in your toolbox should be used to validate the results of another.
Are Leading Indicators Used Outside of the Stock Market?
Yes. Economists use leading indicators to determine the state and potential direction of the economy ahead. Businesses also use leading indicators known as KPIs (key performance indicators) to assess and spur growth.
Some of the most popular leading economic indicators include:
- Consumer Confidence Index. The Consumer Confidence Index is a leading economic indicator that uses data from a consumer survey to determine how confident consumers feel. Do everyday people feel good about the economy and their livelihood, or are they worried or struggling to make ends meet?
- Consumer Price Index (CPI). Economists keep a close eye on CPI data. The CPI uses historical consumer price data to show the current level of inflation. Inflation has a sweet spot at about 2% per year. Readings too far above or below this level often signal economic trouble.
- Gross Domestic Product (GDP). Gross domestic product (GDP) is a measure of the value of all goods and services produced in a country over a predetermined period of time. When GDP is rising, it’s a sign that the economy is doing well and the markets usually will follow. Conversely, if GDP stalls or falls, it’s a sign that economic activity is slowing and financial markets may be in for a bear market ahead.
- Purchasing Managers Index (PMI). The PMI is a leading economic indicator that uses survey data from purchasing managers of corporations across the country. When economic conditions are positive, purchasing managers buy more base materials for the products their companies create.
Some of the most popular leading KPIs businesses use to gauge their progress include:
- Revenue Growth. Revenue growth is a common KPI that compares the most recent quarter’s revenue to revenue in the previous quarter or the same quarter of the previous year. Strong revenue growth is a leading indicator that the company is on the right trajectory, while any decrease in revenue may act as a red flag for investors.
- Earnings Growth. Earnings growth is a KPI that compares the most recent quarter’s profits to the profits from the previous quarter or the same quarter of the previous year. Like with revenue growth, when earnings growth is positive, it’s an indicator that the company is headed in the right direction. Negative earnings growth is much less encouraging.
- Guidance. Many companies provide guidance or predictions about the amount of revenue and earnings the company will generate in the future. The company’s management carefully considers historic data like current revenue and earnings growth when determining reasonable guidance to share with the investing public.
No matter how you access the market, chances are you can use leading indicators to increase your profitability. If you do, make sure to use them in conjunction with other leading and lagging indicators; false signals can become quite costly if you don’t.
The most successful investors use a mix of fundamental and technical data to determine which assets they buy and when they buy them. If you’d like to join the ranks of these Wall Street gurus, start using leading indicators in your research to increase your market profitability.