Measuring Consumer (Over)Confidence

Confidence is an emotion and it is measured subjectively. However, investors seem to be keeping a close eye on the consumer sentiment index lately.

In May, the Reuters/University of Michigan preliminary index of consumer sentiment increased to 69, from 68.7. The index has now risen four months in a row. The index reading for June is set to be released at 9:55 am EST on Friday (6/26).

However, before you get too excited and call your broker with a bunch of "buy" orders, keep in mind that a reading of 69 is still very low by historical standards (see graph below).

You might (should) be asking yourself... how is "confidence" rising when the macroeconomic environment seems to be getting worse (e.g., unemployment is still rising and is now approaching double digits)? The answer lies in the fact that confidence is often times triggered by hope (especially under extreme scenarios). This is why the University of Michigan Consumer Sentiment Index tends to give false readings at the extremes.

To illustrate my point, let's look at how the Index is derived.

The University of Michigan's Consumer Survey Center questions 500 households each month on their financial conditions and attitudes about the economy. The general belief is that the lower this level of sentiment, the less consumers are likely to spend. Conversely, a higher level, which represents greater consumer optimism, increases the prospects for greater consumer spending. The survey focuses on five questions: (1) a rating of household financial conditions, (2) a rating of expected household financial conditions a year from now, (3) a rating of expected business conditions a year from now, (4) expectations for the economy for the next five years, and (5) buying plans.

In theory, the relationship between consumer sentiment and consumer spending makes sense. However, the correlation is meaningless if your dataset has a large margin of error (which it does due to the subjective nature of the survey).

Think about it. How many households do you think were brutally honest with their answers to the survey? My guess is not too many. There is no doubt in my mind that the average household "hopes" that the future will be bright and that they will soon be able to buy more toys... but just keep in mind that reality is usually a story that is only written in hindsight.

Also, don't be fooled by the inherent survivorship bias in this survey. Can you really respond to a survey if your address recently changed (i.e., your home has been foreclosed on) or if your phone has recently been shut off?

Comments

[jeandit75:]

Yes and any poll is a good as the one providing it. What if they suddenly pooled households in the process of refinancing their mortgage or with families that just lost their home, their jobs or that have simply just given up looking for a job. I am not sure the consumer confidence is a real metric. Let's just wait and see the real retail sales. These will tell what the reality is. In France, for those who care, its the beginning of the rebate period and retailers have to drop prices by 40-70% in order to attract customers. Talk about green shoots!

Jun 25 07:15 AM

[Relative Le...:]

I agree with you jeandit75. Retail sales is a key metric to follow...and sales probably won't pick up until employment stabilizes...

That's interesting about France...I wouldn't be surprised to see that happen in the U.S.

Jun 25 09:55 AM

[Relative Le...:]

The June reading was released this morning. The Index increased to 70.8, the highest level since February 2008, from 68.7 in May. Today’s measure compares with a preliminary June reading of 69. I'm not impressed as the reading is still very low. Keep in mind that during the expansion that began in late 2001 and ended in December 2007, the index averaged 89.2.

Also note that the index of consumer expectations for six months from now, which more closely projects the direction of consumer spending, actually slipped to 69.2 in June from 69.4 the prior month.

Jun 26 11:28 AM