What are leading and lagging indicators?
Leading and lagging indicators are tools for assessing the strength of an economy or financial market. In short, leading indicators change before an economic cycle or market trend arrives. In contrast, lagging indicators are based on historical events and provide a reference to historical data on the operation of a particular market or economy.
In other words, leading indicators provide predictive signals (before an event or trend occurs), while lagging indicators generate guidance signals based on trends that have already occurred. These two types of indicators are widely used by investors and traders who use technical analysis (TA) and play an important role in stock, forex and cryptocurrency trading.
In financial markets, the history of technical analysis indicators dates back to the early 20th century. The ideas behind these indicators stem from the Dow Theory, which emerged between 1902 and 1929. At its core, the Dow Theory asserts that price movements are not random, and therefore market movements can be predicted through analysis of previous market behavior.
Besides this, leading and lagging indicators can be used to chart economic trends. Therefore, they are not always related to technical analysis and market prices, but also to other economic variables and indices.
How Leading and Lagging Indicators Work
Leading indicators
As mentioned earlier, leading indicators can predict trends about the future. Therefore, these indicators can be used to predict potential recessions or recoveries. For example, regarding stock market performance, retail sales or building permits.
Therefore, leading indicators tend to outpace economic cycles and are often suitable for short-term and medium-term cycle analysis. For example, building permits are considered a leading economic indicator. Its presence may indicate that the demand for construction workers and investment in the real estate market will increase in the future.
Lagging indicators
In contrast to leading indicators, lagging indicators are used to identify existing trends, which may not be immediately apparent. Therefore, such indicators lag behind economic cycles.
Typically, lagging indicators are often used in long-term analysis, based on historical economic performance or previous price data. In other words, lagging indicators create signals based on market trends and financial transactions that have already been initiated or established.
Synchronous indicators
Although not very popular in the cryptocurrency field, synchronization indicators are still worth mentioning as a third type of indicator. This indicator is somewhere between the other two types of indicators. It operates in near real-time, providing analytical information on current economic conditions.
For example, synchronized indicators can be generated by measuring the working hours of a group of employees or the productivity of a specific industry, such as manufacturing or mining.
It is worth noting that the definitions of leading, lagging and concurrent indicators are not clearly defined. Some indicators are further divided into several different categories based on different methods and scenarios. This is especially common with economic indicators such as gross domestic product (GDP).
GDP is generally considered a lagging indicator because it is calculated based on historical data. However, in some cases it may reflect near real-time economic changes and may be viewed as a synchronized indicator.
Use cases in technical analysis
As mentioned above, economic indicators are also part of the financial markets. Many traders and chartists deploy technical analysis tools of leading or lagging indicators.
In essence, leading technical indicators provide some kind of predictive information. They are usually based on market prices and trading volumes. This means they may reflect market movements that may occur in the near future. However, like other indicators, leading indicators are not always accurate.
Leading indicators used in technical analysis include the Relative Strength Index (RSI) and the Stochastic Relative Strength Index (RSI). In a sense, even candlesticks can be considered a leading indicator because of the trends they create. In fact, these patterns can provide a reference to future market events.
Lagging indicators in technical analysis, on the other hand, are based on historical data and allow traders to understand events that have already occurred. It can also come in handy when spotting new market trends. For example, when an uptrend ends and the price falls below the moving average, this may indicate that a downtrend has begun.
In some cases, both types of indicators may appear together in a single charting system. For example, the Ichimoku Kinko Hyo is composed of both leading and lagging indicators.
Leading indicators and lagging indicators have their pros and cons when used in technical analysis. Leading indicators offer traders the best opportunity when it comes to predicting future trends. The problem, however, is that leading indicators often produce misleading signals.
At the same time, lagging indicators tend to be more reliable because their definitions come from exact historical market data. The significant disadvantage of lagging indicators is that they are less responsive to market movements. In some cases, the timing of a signal for a trader to open a profitable position may be relatively late, resulting in low potential returns.
role in macroeconomics
In addition to being able to assess price market trends, these two indicators can also be used to analyze macroeconomic trends. Economic indicators are different from those used in technical analysis, but can still be roughly divided into leading and lagging.
In addition to the previously cited examples, other key economic indicators include retail sales, house prices, and manufacturing activity levels. Typically, such indicators are thought to drive future economic activity, or at least provide predictable information.
Two other classic examples of lagging indicators in macroeconomics include the unemployment rate and the inflation rate. There are also GDP and CPI, which are often used to compare the development levels of different countries, or to evaluate a country's growth compared with a few years ago or decades ago.
Summarize
Whether applied to technical analysis or macroeconomics, leading and lagging indicators play an important role in many types of financial research. They help interpret different types of data, often combining multiple concepts in a single investment tool.
So, these indicators can ultimately predict future trends or confirm trends that have already occurred. In addition, they are also very useful when evaluating a country's economic performance, either by comparing it with other countries or by comparing it with data from previous years.