It’s easy to understand what a leading economic indicator is and why it leads.  If purchasing managers are increasing their buying, it’s because their businesses need new equipment to do business with.  Increasing consumer confidence will lead to more consumer spending.  Simple.

Trailing indicators are a little more complicated, and the amount of attention being paid at the end of last week to layoffs, initial unemployment claims and the unemployment rate are a great illustration.

Last Thursday, initial claims for unemployment benefits dropped by 38,000 to 550,000.  (There’s a lot of massaging done to these figures to compensate for predictable seasonal fluctuations.)  That may seem like a lot of new people hitting the unemployment rolls, but the really important statistical tidbit is that analysts had expected 580,000 new claims.  a

Then last Friday, the figure for July job losses in the U.S. was released, and the number fell from the June level of 443,000 to 247,000.  Again, economy watchers had expected the number to decline, but were expecting a higher figure of 320,000.  The headline unemployment rate also dipped from 9.5% to 9.4%, while analysts had forecast 9.6%.

Now for most of us, a 9.4% unemployment rate and 550,000 new names applying for unemployment seems like bad news even if analysts were predicting higher numbers for both.  But that brings us back to why employment is a trailing economic indicator and what that means for stock investors.

For historical perspective, let’s go back to the last big market decline, the one that followed the bursting of the Tech Bubble in 2000.  The market topped out in January of that year, and in that month unemployment fell to 4.0%, its lowest level since January 1970!  As the market began its torturous decline, unemployment remained at those historically low levels, making it all the way through 2000 within a tenth of a percent of that reading and finishing the year with three months of unemployment at 3.9%.

Note that unemployment rates actually went down for 12 months following the market high.

Both the Dow and the S&P 500 bottomed in October 2002 (October 10, for those of you with a taste for exact dates), when unemployment rates were in their third month of registering 5.7%, not bad by historical standards, but well up from their 3.8% low in April 2000.  Unemployment continued to creep up, even as the stock market was getting back into gear, and the rate actually peaked at 6.3% in June 2003, eight months after the market low.

Why does this happen?  What is it that keeps joblessness high and produces headlines about a “jobless recovery?”  You have to put yourself in the position of a CEO to understand.

When recessions hit, CEOs respond to lower demand for products and services by laying people off.  (They may think of it in terms of lowering costs, but generally speaking, firing people is one of the first items on The Frugal CEO’s To-Do List.)  And the earlier and deeper the job cuts, the better the bottom line.

But when the recovery comes, the last thing the successful company head wants to do is to get ahead of it with hiring.  Economic downturns are fragile, and weathering an economic whipsaw with an expensive group of inexperienced new names on the payroll can be risky.

So the successful business fires early and hires late, when the risk has diminished enough to make it worthwhile.

That’s what makes unemployment a trailing indicator.  The same impulse that pushed it up in the first place keeps it up until the recovery of the economy is a proven fact.

So when you see the headlines announcing that unemployment has stopped growing, you’re actually seeing a big billboard trumpeting the onset of a full recovery of the economy.

Equity markets knew that months ago, which is also traditional.  The parade of economic recovery always proceeds in the same order.  The equity markets lead the way, the economy follows, and employment always trails months behind.