The recent findings of the University of Michigan’s (UMI) Consumer Sentiment survey add another layer of worry to the state of U.S. stocks and the overall economy.
Rise in Consumer Sentiment Raises Red Flags
Contrary to popular belief, consumer sentiment is considered a contrarian indicator, as it often goes against conventional wisdom. The latest UMI gauge reveals a significant spike in consumer sentiment over the past few months. In fact, the increase from June to the preliminary July level is the largest jump observed since December 2005. Furthermore, when comparing the sentiment measure to the previous year, it has surged by an impressive 21.1 percentage points. This jump is one of the most substantial 12-month increases recorded since the inception of this monthly survey back in 1978.
Historical Performance Analysis
A closer look at historical data reveals that similar jumps in consumer sentiment have been followed by below-average performance. The accompanying table provides evidence of this trend. Notably, any jump that exceeds a 17 percentage point increase in the trailing 12-month period qualifies as being within the top 5% of months. Based on this threshold, July’s preliminary reading comfortably falls within this subset. To put this into perspective, it’s crucial to note that the performance numbers for the S&P 500 index (SPX) mentioned in this analysis account for inflation-adjusted total returns.
The Truth About Consumer Sentiment and Stock Market Returns
It may come as a surprise, but soaring consumer sentiment does not always result in above-average stock market returns. While many may assume that positive consumer sentiment would lead to a booming stock market, the reality is quite different. Consumer sentiment is more of a coincident indicator rather than a leading one.
This fact has been evident throughout the past year. Investors became increasingly optimistic and bought equities, causing the market to surge. As a result, the expected higher stock market returns associated with soaring consumer sentiment have already materialized.
The reason behind this phenomenon lies in our tendency to overreact. When consumer sentiment is high, we often become overly exuberant. Conversely, when sentiment declines, we tend to become despondent. These emotional swings tend to be followed by corrective movements in the market, as contrarian analysis has taught us.
Let’s take a look at the situation one year ago. The UMI sentiment index was plummeting, experiencing its most significant 12-month decline since 1978. However, despite the negative sentiment, today’s S&P 500 stands at an impressive 20% higher on a total-return basis.
Interestingly, the sentiment picture today stands in stark contrast to what it was a year ago. Bulls in the market should take note of this disparity.
Mark Hulbert is a regular contributor.