U.S. consumers are feeling very good about the economy, but history suggests that may ultimately lead to investor disappointment.
Multiple reads of confidence have come in extremely strong lately, and while many view this as an optimistic sign for spending and demand, many market watchers also see it as a contrarian signal, one that suggests a complacency building in the market. That dynamic, in turn, could signal tepid future returns.
On Tuesday, the Conference Board’s consumer confidence index jumped to its highest level in 18 years, signaling a level of optimism that is near all-time highs. That comes on the heels of a reading of small-business sentiment, which hit a record in August. And as pointed out by Liz Ann Sonders, the chief investment strategist at Charles Schwab, a Gallup poll showed that the percentage of Americans who see economic issues as their biggest problem “is at the lowest level in decades.”
Previous lows on with this poll question have occurred near market peaks, including in the late 1990s and before the financial crisis.
Percentage of Americans who see economic issues as the most important problem is at the lowest level in decades@Gallup @SoberLook pic.twitter.com/zFqASpB582
— Liz Ann Sonders (@LizAnnSonders) September 25, 2018
According to Charlie Bilello, director of research at Pension Partners, high levels of confidence tend to be followed by “below-average returns and a lower probability of a positive return” going forward.
“When there’s good news in the economy (high consumer confidence), investors are willing to pay a higher multiple for a given level of earnings than when there’s bad news (lower consumer confidence),” he wrote in a blog post published in August. “That’s important when it comes to stocks because higher valuations tend to be associated with below average forward returns.”
Per Bilello’s data, when consumer confidence readings are in the top decile, the average forward return for the S&P 500 SPX, +0.09% over the coming year is 3.8%. When confidence is in its lowest decile—meaning consumers are at their least confident about the market—the average return is significantly higher, at 19.3%. Overall, the average return is 12.2%.
When confidence is low, that tends to be following by strong gains for an extended period. According the data, investors have historically seen double-digit returns every year for seven years (on an annualized basis) following weak confidence readings. Furthermore, there is an extremely high likelihood of positive returns following low confidence readings.
On the other hand, when confidence is high, as it is now, returns are slightly negative on a two-year, three-year, and four-year basis. In addition, there is a greater-than-even chance of negative returns in the subsequent years, as demonstrated by the table below.
Courtesy Pnesion Partners
Torsten Sløk, chief international economist at Deutsche Bank Securities, recently wrote that confidence was “at levels normally indicating a recession is imminent.” On a related note, strategists at JPMorgan Chase & Co. recently wrote that the current strength of the economy and stock market could embolden President Donald Trump on geopolitical issues, risking “a major miscalculation from sanctions that are tough to calibrate.”
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While consumers are extremely optimistic about the economy, many on Wall Street aren’t, or, at least, they are unabashedly euphoric. According to the latest survey of investor sentiment by the American Association of Individual Investors, the number of investors who describe themselves as bullish on the market—meaning they expect prices will be higher in six months—is below the historical average.
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