Vital Signs To gauge the health of the economy and the financial markets, check out these four key economic indicators.
By Walter Updegrave

(MONEY Magazine) – Will the slowing economy teeter into recession? Or will the Federal Reserve succeed in breathing new life into the economy--and the stock market--by cutting interest rates?

It would be great if there were a simple way to get quick answers to such questions. But short of having economists and psychics join forces to develop an economic version of one of those fortune-telling eightballs, I can't think of one.

Which brings us to the only real option investors have for trying to gain a sense of what might lie ahead: tracking a select group of economic indicators. The operative word here is select. As anyone who's watched CNBC or surfed the Web knows, you can quickly find yourself drowning in a flood of confusing economic minutiae. Our goal is to help you home in on a few easily accessible stats that provide insight into several areas of the economy and don't require a Ph.D. in economics to understand.

Below, I'll go over four key gauges that we think fit that bill. (If you have a higher tolerance for this sort of thing, you'll find a more exhaustive--though not exhausting--list of indicators in my latest Investing 201 column at www.money.com.) But first, a few caveats. No set of indicators is going to provide you with a connect-the-dots path to the future. Even major turning points tend to be clearest in hindsight. For example, the Business Cycle Dating Committee of the National Bureau of Economic Research didn't announce the starting date of the 1990 recession until April 25, 1991--a month after it had ended. And even when all economic signs seem to point in the same direction, it's not a given that the economy will follow. In economics, as in Florida elections, outcomes are often hard to predict.

One more thing: If the market is working correctly, stock prices should reflect investors' future expectations for the economy. In fact, stock prices often drop six months or so in advance of economic slowdowns and soar about six months before a recovery. (That said, the market isn't a perfect prognosticator. As economics Nobel Laureate Paul Samuelson once quipped, "The stock market has predicted nine of the last five recessions." That line is considered a laugh riot in economic circles.) So even if I were supremely confident about my reading of the economy, I'd be wary of using that knowledge to make big bets on specific investments.

1. THE EMPLOYMENT REPORT. Typically released the first Friday of each month, the Employment Situation Summary, as the Bureau of Labor Statistics calls it, provides a quick update on the job market. Growing employment leads to increases in consumer spending, which accounts for two-thirds of the U.S. economy. Thus most economists consider the report an advance peek at future economic growth.

The financial press usually zeroes in on the unemployment rate, which has recently hovered at or near its all-time low of 3.9%. But that figure says more about where the economy has been than where it's headed. To get a glimpse of the future, check out the increase in "nonfarm payroll employment," or the number of new jobs created in the economy each month.

Basically, job growth is a harbinger of economic growth. Indeed, a little more than a year ago, when investors were more concerned about the economy overheating than fizzling, strong job gains actually sent the market down by raising the specter of rising inflation. Lately, though, investors have been disturbed by the slowdown in job creation (see the chart on the opposite page). In 1997 and 1998, for example, we added jobs at a frenetic pace of more than 250,000 a month on average. In 1999 the monthly rate slowed to fewer than 230,000, and it slipped below 160,000 last year. By the fourth quarter of last year, an average of only 77,000 new jobs were being created each month, a drop of 70% from 1999's fourth quarter.

That kind of decline doesn't guarantee a recession, but it certainly suggests much slower growth for the economy--and corporate profits--in the months ahead. If job creation numbers actually go negative for several months running, that would definitely be a red flag, since sustained job losses typically occur only during recessions. You can find the employment figures on the BLS website at www.bls.gov/ceshome.htm.

2. CONSUMER CONFIDENCE. Employment data can tell you about consumers' ability to spend but not about their willingness to spend. For that, economists and investing strategists turn to a variety of surveys that gauge the fickle phenomenon known as consumer sentiment. One of the most widely followed is the Conference Board's consumer confidence index, released on the last Tuesday of every month.

The idea behind the index is simple. "We're measuring changes in consumer attitudes about the economic situation," says Lynn Franco, director of the Conference Board's Consumer Research Center. "If there's a dramatic shift from spending to saving, it can apply the brakes to economic growth."

The board polls 5,000 different households each month, asking people how they feel about current and future business conditions, the job market and their own income prospects over the next six months. The board's number crunchers massage those responses into an index that measures confidence in the economy. A rising trend in the index suggests that consumers are becoming more upbeat--and more likely to open their wallets and propel the expansion forward. A downward trend indicates that consumers are more likely to pare back spending. Lately, the trend has been negative, as the consumer confidence index dropped in December for the third month in a row.

The consumer confidence index grabs most of the attention, but you get a better reading on what lies ahead from the board's expectations index. This gauge, which is derived from the overall confidence index, measures how well we think the economy and our personal finances will be doing six months down the road. As the chart above shows, this index has also been on a three-month slide, dropping to 95.8 in December, its lowest point since October 1998.

While the downward trend in expectations certainly suggests that economic growth in the first half of this year will be much slower than the 5% or so pace of the first half of 2000, it doesn't appear to be steep enough to presage imminent recession. "Generally, the expectations index has to dip below 80 and stay there two months or so before we consider it a warning of recession," says Franco. "We're not close to that level now." You can get the current readings on the consumer confidence and expectation indexes by going to the Conference Board's Consumer Research Center website at www.conference-board.org/products /c-consumer.cfm.

3. PURCHASING MANAGERS' INDEX. After taking the pulse of consumers, the industrial sector of the economy is the next place to turn to for clues about the economy's future direction. For a timely assessment of our industrial might, most economists track something called the purchasing managers' index (PMI). Each month, the National Association of Purchasing Management surveys roughly 400 manufacturing executives who buy raw materials and oversee inventories, querying them about production, hiring and new orders at their firms. From their responses, NAPM computes an index of industrial activity for that month, releasing it on the first business day of the following month.

Most pundits focus on whether the index falls above or below 50, the break-even point for the manufacturing sector. For gauging the direction of the overall economy, however, the key index level isn't 50, but 42.7. If the index comes in above that number, the economy continues to grow; anything below 42.7 means the economy is contracting.

The latest news from the PMI hasn't exactly been cheerful. In December, the index dropped for the fifth consecutive month, slipping to 43.7 (see the chart at the bottom of page 79). That reading leaves little doubt that the manufacturing sector is in trouble and that the economy has been slowing. So far, however, the index isn't trumpeting a recession.

By the way, this index seems to carry some weight with the gang at the Fed. After the weaker than expected December PMI figure was released at 10 a.m. on Jan. 2, the Nasdaq slumped 7.2%. By early afternoon of the next day, the Fed had made its surprise move to cut the federal funds rate by half a percentage point, citing, among other reasons, a further weakening in economic production. You can get details of the PMI index by clicking on the NAPM Report on Business banner at the NAPM website (www.napm.org).

4. LEADING ECONOMIC INDICATORS. If you don't have the time or the inclination to track a variety of gauges, consider tracking a bunch of benchmarks rolled into one. That's where the index of leading economic indicators, released monthly by the Conference Board, comes in. Developed during the Depression to predict changes in growth roughly three months ahead, the index reflects 10 separate components, including the length of the workweek, building permits, interest rates, the money supply and stock prices. While putting the index together may take some major calculating power, following it doesn't. Basically, when the leading indicators are rising, that's a sign the economy will continue to chug along in the near future. When the indicators stagnate or fall, that's a signal that growth is slowing.

The indicators have done a good job over the years at anticipating slowdowns, but their record at predicting recessions is more mixed, leading some economists to dub the index "the misleading economic indicators." For example, the oft-invoked rule of thumb that three consecutive monthly declines in the indicators means we're headed for recession has generated at least one false signal during six of the past eight expansions.

As the chart at left shows, the leading indicators clearly suggest that the economy will continue to cool. The December figure of 108.3 represented the third consecutive monthly decline and was even lower than its level a year ago. In a healthy economy, Conference Board economist Ken Goldstein points out, you would expect to see the composite increase by 1% or so over 12 months. Still, he believes that the indicators are projecting only slower growth, not recession. "It's not as if the economic environment has caved in," says Goldstein. "We're finished with the 5% growth we saw midway through last year, but we're probably not going to have too much worse than 2% to 3% this year." You can find the latest leading indicator figures at the Business Cycle Indicators section of the Conference Board website at www.tcb-indicators.org.

Of course, in the fast-changing world of markets and the economy, all outlooks are subject to revision. So unless that forecasting eightball actually becomes a reality, I suggest you keep one eye on our indicators, and the other on the Fed.