Monday, January 16, 2012

The ECRI Weekly Leading Index, unmasked

- by New Deal democrat

This is a continuation of my series reverse engineeering ECRI's Weekly Leading Index (WLI). I began by noting that ECRI's founder, Prof. Geoffrey Moore, in 1990 initially proposed a Weekly Leading Index made up of indicators whose values could be computed weekly, or if monthly were reported at the beginning of the next month. While this index would be a little less reliable than the Long Leading and Short Leading Indeces, it would have the advantage of being more timely.

Its weekly components were:

Real M2
Dow Jones Bond Average
S&P 500 stock price index
Initial claims for unemployment insurance
Journal of Commerce change in commodity prices
Dun and Bradstreet new business formation and large business failure
Real estate loans, deflated, growth rate

The quickly reported monthly components were:

Average workweek in manufacturing
Layoff rate under 5 weeks
ISM manufacturing vendor performance
ISM manufacturing inventory change

The questions remained, were the monthly components included in the final result? Were the weekly components weighted? Were there any changes in the list? As to the last, I have noted that it is almost impossible to generate a decline such as ECRI claims for the WLI in 2011 if Real M2, which experienced a tsunami-like increase in late summer, were still included. I have suggested that the credit spread between government and corporate bonds might have replaced Real M2 in the list at some point.

It appears that ECRI spokesman Lakshman Achuthan himself has all but settled the issue. Appearing as a guest author at Barry Ritholtz' "The Big Picture" blog in 2009, he wrote:
Our leading indexes are composites of key drivers of the business cycle. Correlations are not part of our process which focuses on the relationship of indicators around inflection points in growth and inflation. .... ECRI does not suggest that the LLI is a perfect leading indicator, but it does not include stock prices and has a longer lead than stock prices over growth rate cycle turns.

You can read more about the Weekly Leading Index (formerly known as the Business Week leading index) here:
(my emphasis) (UPDATE: To avoid confusion, please note that the reference to stocks not being included, is to ECRI's "long leading index," a completely separate index).

The link takes you to the book "Beating the Business Cycle," authored by Achuthan in 2004. There, at pp. 108-09 he says
"To monitor developments on a more frequent basis, Moore helped develop a Weekly Leading Index (WLI) in 1983. Some of the components of the WLI, like initial jobless claims, had long been available on a weekly basis. Others had to be created from scratch, like the Journal of Commerce-ECRI industrial materials price index, designed to measure inflation in a broad range of industrial raw materials. Starting in 1983, the weekly index was published in Business Week magazine. Known at the time as the Business Week Leading Index, ... In the late 1990s, ECRI began to publish the index through our own website,
Then, at pp. 135-36 he elaborates:
"We .. determin[e] good proxy measures for the various drivers [of the economy] -- that is, individual leading indicators -- and combin[e] them into composite indeces which objectively summarize their information. For example, in constructing the Weekly Leading Index (WLI) , we use a specific leading indicator -- initial claims for unemployment insurance -- to represent employment, which is a key driver of the business cycle. Likewise, we pick out six other specific leading indicators that are updated weekly, to represent other cyclical forces. Because the seven indicators are rarely unanimous, we summarize them into the composite WLI ...."
(my emphasis)

So that is pretty clear. There are seven indicators (confirming that the early monthly reports are not part of the index), and specifying that initial jobless claims and the JoC-ECRI industrial commodity index are two of the components.

Finally, a little google searching reveals that several issues of Business Week including the "Business Week Leading Index" are archived online. Here is a screenshot of one of them, edited only to delete a line describing another unrelated index. Note that it includes precisely seven indicators:

Another example can be found here.

So that just about settles it. The referenced "real estate loans" are sourced to the Federal Reserve Bank and weekly updates can be found here.

It appears that the index is weighted. Also, I continue to question whether Real M2 survived the transition, just as it appears that AAA bonds were substituted for the similar Dow Jones Bond Average. With those caveats, the components of the WLI are unmasked.