Earlier this week, the latest U.S. Consumer Confidence index figure was released, showing that consumers are the most confident they’ve been in 16 years.
This might sound great but as they say, the higher you are the farther you fall.
Let me explain.
The Consumer Confidence index is created from a monthly survey of 5,000 U.S. households. The questions and the way they’re collected are largely unchanged since 1967. This means that it’s one of the longest running, and most consistent, indicators of the direction of the American economy.
The survey asks respondents to comment on business and employment conditions today, and their expectations of where they’ll be in six months. People who answer the survey are also asked about their expectations of family income in six months.
The U.S. consumer is a huge financial force. It’s the largest component of domestic GDP. And U.S. consumers – though they account for just under five percent of the global population – are responsible for around a quarter of the US$43 trillion that households all around the world spend every year. (We’ve written about how the Chinese consumer will be one of the most important forces in the global economy… in the meantime, the American consumer still sits on that throne, though.)
So the Consumer Confidence figure is an extremely important and closely-watched indicator – both for the American economy and for the global economy. It’s a gauge of optimism about the overall state of the economy and the consumer’s personal financial decisions. If consumers are happy and optimistic, they’ll tend to spend more and save less.
Over time, we see clear trends and cycles in consumer confidence. Take a look at the chart below showing the index all the way back to its inception in 1967.
The first thing you’ll notice is the index isn’t above 125 (its current level) very often. In the past 50 years, it only hit that level in two cycles.
And more telling, with the exception of 1997 to 2000, when the index is at or near the level it is now, we often see a sharp reversal soon thereafter.
Consumer confidence and the stock market are also closely linked. If we look back at the last three bull markets in U.S. stocks, we see a close correlation with the consumer confidence index (see chart below). That means that consumer confidence and the U.S. stock market tend to move together.
This makes sense. Consumers are confident when they have jobs, and feel a sense of stability – and they then feel more inclined to spend than save. And given the huge importance of the U.S. consumer to the economy, consumer spending means profits and economic growth.
So, with confidence at a 16-year high, should you be rushing out and buying stocks?
A strong consumer confidence figure is good for the economy. But it’s a lagging indicator, not a leading one. That means that consumer confidence tells you about the state of where the economy is, not necessarily where it’s heading. It’s a lagging indicator because economic growth takes some time to filter through to consumers in the form of employment and wages, which are primary drivers of how the index is determined.
In the short term, strong U.S. consumer confidence is positive for:
The U.S. dollar – Higher consumer demand suggests that prices will rise faster. As a result, the Federal Reserve may lean towards raising interest rates faster – which makes the dollar a more attractive asset.
Consumer discretionary stocks – In periods of weaker economic growth and lower consumer confidence, consumer staple stocks (like Kraft Heinz, Colgate-Palmolive, and Proctor & Gamble) tend to outperform. These companies sell your everyday necessity items. But when the person in the street has a little extra cash in his pocket and feel good about their prospects, they’re more likely to upgrade their phone, take a vacation or splurge a little extra cash on something nice.
Asian exporters – China is by far the biggest exporter to the U.S. All those TV’s, phones, and iPads are made in China. And coupled with a stronger dollar, these imports are even more attractive to the U.S .consumer (because they’ll be cheaper for American buyers with the stronger U.S. dollar). South Korea and Japan are other large U.S. export markets.
In the medium term, U.S. stocks are still expensive by historical standards. The S&P 500 trades at a forward price-to-earnings ratio of around 18 times. That compares to an average of about 16 times since 1990.
We’ve written about how the so-called Trump Rally is going to end soon. So far, it hasn’t, and the S&P 500 is up 5.3 percent in 2017 so far. But such a high Consumer Confidence figure suggests that – if history holds – U.S. stocks are getting very close to their high for this market cycle.
Caution is preferable to exuberance.
This article by Tama Churchouse originally appeared on Stansberry Churchouse Research, originally known as TrueWealth Publishing.