Investors track a lot of business, economic and stock price indicators to make decisions about what to buy, hold or sell in the share market. These indicators are generally of two types – lagging indicators and leading indicators. Lagging indicators are those which tell us about an event after it has happened whereas leading indicators are predictive in nature — they signal what is likely to happen.
Leading and lagging indicators aren’t only specific to the share market. They also appear in areas such as economics, management, finance and safety. For example, consumer sentiment and bond yields are leading indicators. On the other hand, unemployment numbers, measures of inflation such as wholesale price index and consumer price index, amount of loans disbursed and car sales are some prominent lagging indicators.
One interesting case in point are GDP (gross domestic product) statistics. If we are talking about GDP estimates, then they are leading indicators. However, if GDP of past years are being considered then they are lagging indicators. As such GDP statistics are called coincident indicators as they can’t be delineated perfectly in the dichotomy of leading vs lagging indicators.
Leading indicators vs lagging indicators: advantages and disadvantages
a) While lagging indicators are easier to identify, they don’t capture the current trend. For example, when there is a reversal in the direction of a stock price, these indicators will tell you that the reversal has happened. However, it might be too late to make gains or arrest losses by then.
b) Leading indicators could help a share market investor stay ahead of the curve but they could also give false signals.
c) One must appreciate that these indicators are based on data collection and algorithms. As a result, rough edges in any of one of the factors might lead to an incorrect indication.
d) False signals is an issue with leading indicators as they are usually quite fast to respond to changes in stock prices.
e) However, false signals could be given by lagging indicators too as there is inertia in responding to reversal of trends
Frequently used lagging indicators in the share market
1) Exponential moving average (EMA): It’s a tool that gives more importance to the latest observations. That’s how it is different from the simple moving average which gives equal importance to all data points. EMAs can be constructed for any length of time. It is advisable to use as much historical data as possible for the EMA of a particular stock to improve its accuracy. The longer period EMAs are slower in changing direction.
2) Moving average convergence/divergence (MACD): This is a tool that helps investors identify the bullish and bearish nature of a particular trend. It is a function of two EMAs and can indicate the momentum and duration of a trend among other things.
3) Average Directional Index (ADX): This technical analysis tool helps gauge the strength of a trend. It is denoted by a number ranging from 0 to 100.
Frequently used leading indicators in the share market
1) Relative strength index (RSI): As the name suggests, RSI is a lagging indicator that tells investors when a security is oversold or overbought in the market.
2) Stochastic oscillator: This indicator predicts the turning points in the market by comparing the historical price range of a security to its closing price
3) Williams %R: This tool is an indicator of the security’s proximity to the high and low in a particular trading period which is generally two weeks.
Four important points of difference between leading and lagging indicators
1) Lagging indicators provide fewer false signals which might mean a smaller probability of stop-out losses.
2) Another key difference between leading and lagging indicators is that the latter is generally more accurate by virtue of the fact that it is the result of post facto data gathering and calculations.
3) Given the slow nature of lagging indicators, the signals might not come in early enough to book large gains by capturing a bigger part of the move.
4) Another major difference between leading and lagging indicators is that the former kind is generally more useful in day trading whereas the latter would be more helpful in swing trading
Leading indicators vs lagging indicators: Which type wins?
Making a pick among multiple leading indicators vs lagging indicators at a particular juncture is tough. A successful trading strategy can be devised by combining inferences from both rather than completely overlooking one while blindly trusting another. Making moves in the market by balancing both kinds of indicators is how investors generally operate. As such one doesn’t have to make a hobson’s choice in the leading indicators vs lagging indicators paradigm.