Understanding the LEI and Its Divergence from the Stock Market
The Leading Economic Index (LEI) is a composite indicator published by The Conference Board, designed to forecast future economic activity and signal potential recessions about 7-10 months in advance. It aggregates 10 components: average weekly manufacturing hours, average weekly initial unemployment claims, manufacturers' new orders for consumer goods and materials, ISM New Orders Index, manufacturers' new orders for nondefense capital goods excluding aircraft, building permits, S&P 500 stock prices, Leading Credit Index, interest rate spread (10-year Treasury minus federal funds rate), and average consumer expectations for business conditions. These are standardized and averaged, with the index benchmarked to 100 in 2016.
Historically, a sustained decline in the LEI has reliably preceded recessions and stock market downturns, as seen in the provided chart. For instance, LEI drops aligned with market declines before the 2001 dot-com bust, the 2008 financial crisis, and the 2020 COVID recession. However, since its peak in early 2022, the LEI has fallen steadily (down about 20% as of July 2025, reaching 98.7 after a 0.1% monthly drop), yet the stock market (e.g., S&P 500) has surged over 50% in the same period, driven by tech and AI optimism. This divergence is unusual in duration and magnitude, marking the longest such streak without a recession in over 60 years of LEI data.
Why the Prolonged Divergence This Time?
Several structural and cyclical factors explain why the LEI hasn't triggered the expected market pullback or recession, based on analyses from economists and institutions like The Conference Board, Fisher Investments, and J.P. Morgan. Unlike past cycles, where manufacturing slumps quickly rippled through the economy, today's dynamics are different:
- Shift to a Service-Dominated Economy: The US economy is now about 70-80% services (e.g., healthcare, finance, tech services), up from ~60% in the 1980s. The LEI is disproportionately weighted toward manufacturing-related components (e.g., new orders, weekly hours), which have been weak due to post-pandemic demand pull-forward, global supply chain issues, and tariffs. Services, however, remain robust, supporting overall GDP growth (projected at 1.6% for 2025 by The Conference Board). This "two-speed economy" means manufacturing weakness drags the LEI down without derailing broader growth or markets.
- Distorted Yield Curve Signal: The interest rate spread component has been negative since mid-2022 due to an inverted yield curve (short-term rates higher than long-term, often from Fed hikes). Historically, this predicts recessions, but this time it's lingered without one, thanks to strong household/corporate balance sheets, fiscal stimulus (e.g., Infrastructure Act, CHIPS Act), and low locked-in mortgage rates limiting housing weakness. Elevated rates since 2022 explain much of the LEI's decline, but the economy has proven resilient.
- Consumer Expectations vs. Actual Behavior: As noted in the second figure, average consumer expectations for business conditions contributed -0.19% to the LEI in July 2025 and -1.38% over the prior six months. Sentiment has been depressed since 2021 due to inflation, political polarization, and media negativity, but actual consumer spending remains strong (supported by rising real wages, low unemployment ~4%, and excess pandemic savings). This gap means the LEI overstates pessimism.
- Stock Market's Tech/AI Dominance: The S&P 500 is increasingly cap-weighted toward tech giants (e.g., "Magnificent Seven" like Nvidia, Microsoft), which account for ~30% of the index. These firms thrive on AI, software, and digital services, less tied to traditional economic cycles. AI hype has fueled market gains (S&P 500 up ~15% YTD as of August 2025), even as LEI signals weakness. The LEI includes stock prices as a positive component (+0.18% in July), but this hasn't offset drags elsewhere. Post-pandemic, markets have decoupled from goods-heavy indicators, with AI driving "virtual" growth (e.g., cloud computing, apps) over physical manufacturing.
- Post-Pandemic Structural Changes and Policy Support: Lockdowns distorted demand (e.g., goods surge then bust), while massive fiscal/monetary aid (trillions in stimulus) built buffers. Tariffs and geopolitical tensions add uncertainty, but businesses are adapting (e.g., reshoring). The Conference Board notes the LEI's recession signal triggered again in July 2025, but they don't forecast a downturn, instead expecting slowdown from tariffs in H2 2025.
In summary, the LEI's predictive power is intact but diminished in this cycle due to these evolutions. It's flashing warnings, but models like J.P. Morgan's put recession odds at ~20% for 2025, lower than LEI implies.
What Is the ISM New Orders Index?
The ISM New Orders Index is a subcomponent of the Institute for Supply Management's (ISM) Manufacturing Purchasing Managers' Index (PMI), a monthly survey of ~300 US manufacturing firms. It's a diffusion index: Respondents report if new orders are higher, lower, or unchanged vs. the prior month. The index = (% higher) + 0.5 × (% unchanged), ranging 0-100. Above 50 signals expansion; below, contraction. July 2025 reading: 47.1 (contraction for most of the past three years).
It measures demand for manufactured goods, a leading gauge of production, employment, and GDP. Historically, it correlates with stock market health as manufacturing drives cycles (e.g., inventory buildups/recessions).
Why Does It No Longer Indicate Stock Market Health?
The index still reflects manufacturing vitality but has decoupled from markets due to:
- Declining Manufacturing Share: Manufacturing is ~11% of US GDP (down from 20%+ in the 1980s), while services dominate. Weak new orders (e.g., -0.18% LEI contribution in July) signal industrial slowdowns but not broad market crashes.
- Market Shift to "Virtual" Products: Yes, your hypothesis is spot-on. The S&P 500's growth is increasingly from intangible/tech sectors (AI, software, cloud services) rather than physical goods. AI-driven firms like those in semiconductors or data centers benefit from digital demand, not traditional orders for machinery/consumer durables. This reduces the index's relevance—e.g., Nvidia's AI chip boom boosts markets but isn't captured in ISM's manufacturing focus on broader orders.
- Global and Post-Pandemic Factors: Supply chains are diversified; US manufacturing hurts from tariffs/exports, but tech exports (e.g., software) thrive. The index has contracted since 2022 without tanking markets, as services offset.
Overall, while LEI and ISM highlight risks (e.g., potential 2025 slowdown from tariffs), the stock market's resilience stems from tech innovation and service strength. Monitor updates, as The Conference Board sees weakening but no recession ahead.
