Common Misconceptions: Consumer Confidence and Levels of Employment
"Perhaps the scariest aspect of our times is how many people think in talking points, rather than in terms of real world consequences."
-Thomas Sowell
From the Financial Times this week:
US consumer confidence leapt again in August to hit its highest point in nearly two decades as Americans’ view of the economy keeps growing rosier.
If you’re like most people, you believe this is good news for consumer spending – roughly two thirds of the economy – which in turn is good for the stock market. This is a common misconception.
Discussions around consumer confidence surveys (a psychological measure) make for good TV, but it is not a helpful tool for telling us what will happen next. This is because consumer confidence is not a driver of consumer spending, it is a by-product of consumer spending.
The below chart provides an excellent visual of why we should avoid extrapolating high confidence into better times ahead. It shows that historically consumer confidence has peaked right before a recession has occurred. A very different outcome than the one the media often implicitly or explicitly states is more probable!
(Note: the dark brown line represents consumer confidence, the shaded regions represent recessionary periods)
For an explanation on why so many people fall for this misconception let’s turn to the very underrated book by Joseph Ellis, Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles:
On any given day, a quick scan of the Wall Street Journal, the Financial Times, The Economist, Fortune, and other business publications yields brief reports on the latest of a great variety of economic data series. In each, an advance or decline per se is seen to be “positive” or “negative.” However, few of these reports contain any longer-term history of the series and its relationship to another economic data series. For example, if we see a report on the rise or fall in a consumer confidence index, rarely is it accompanied by a chart tracing that index’s historic relationship with, and implied causality of, uptrends or downtrends in consumer spending. How can readers be informed by economic reports if the latest reading on the economic series in question is presented in a vacuum?
Mr. Ellis is no novice on this subject. From 1970 to 1994 he headed Goldman Sachs Retail Research Group and was the first retail analyst to be ranked #1 by Institutional Investor for 18 consecutive years. While Ellis is not the first to point out the information-vacuum problem, but in the age of endless information it is likely a more important to understand how this vacuum can fog up our investment-thinking.
A related insight from Ellis’ book has to do with the misconception that high levels of employment should lead to better times ahead.
“……. here’s where most predictions of consumer spending get tripped up. Most forecasters—economists and non-economists alike—intuitively and emotionally regard employment, or jobs, as the most important input to wages and salaries and personal income. After all, a job is the cornerstone of each individual consumer’s spending power, the root of his or her economic well-being, and a cornerstone of consumer psychology. In short, we all have an emotional knee-jerk response to view employment as the key driver of income and psychological well-being (read consumer confidence) that makes consumer spending possible.
Although this view of employment is accurate to a certain extent, it misses the point that workers are invariably hired after the economy improves, or fired after it deteriorates, and therefore employment is always—not sometimes, but always—a lagging indicator in the economic cycle.”
The Lesson: Too often, investors watch the flow of information come in without asking whether that flow is useful or predictive. If an investor chooses to actively seek out true investment information they should also make it a habit to identify the type of information that leads people to faulty investment conclusions.