Daily Gains Letter

Consumer Confidence Increases: Will the Stock Market Follow?

By for Daily Gains Letter |

Consumer Confidence Increases: Will the Stock Market FollowIn May, the Thomson Reuters/University of Michigan’s preliminary consumer sentiment index, an early gauge of consumer confidence in the U.S. economy, registered at 83.7, up from 76.4 in April. This is the highest the index has been since July of 2007. Economists were expecting the index to register at 78. (Source: Schnurr, L., “May consumer sentiment highest in nearly six years,” Reuters, May 17, 2013.)

Why is consumer confidence important? It is often said that consumer confidence can be a good indicator of where the key stock indices in the U.S. are headed next. The reasoning behind this is that the U.S. economy thrives on consumer spending—meaning the more Americans spend, the more the economic growth.

If consumers are pessimistic, they will spend less. Think of it this way: if you find that businesses in the industry you work in are cutting jobs—say, because of recession—would you be spending as much? Or would you hoard and save as much as you can? This phenomenon may result in lower corporate profits and a decline in the stock market.

Similarly, if consumers are confident—for example, they think their jobs are going to be there for a while—they will not be hesitant to spend, meaning higher profits leading to a higher stock market.

Take a look at the chart below:

University of Michigan Chart

Chart courtesy of www.StockCharts.com

Consumer confidence (red line in the chart above) and the stock market/S&P 500 (green line) seem to be heading in similar directions. Looking at the chart above, the hypothesis that the stock market goes higher as the consumer sentiment increases seems to be true. The S&P 500 and consumer sentiment have a correlation of 79%.

Now with this comes a question: how does one actually profit from rising consumer confidence?

Even though an increase in consumer confidence may cause the entire stock market to rise, there are sectors that can do much better as consumers start to spend. Consider the high-end retailers; when consumers have more money, they tend to spend more on luxury goods.

One way investors can profit from rising consumer sentiment is by looking to place where consumer spending affects the most. They might want to look at exchange-traded funds (ETFs) like the Guggenheim S&P 500 Equal Weight Consumer Discretionary (NYSEArca/RCD).

This ETF provides investors with exposure to the companies in consumer cyclical industries, which generally are highly dependant on consumer spending and confidence. This ETF buys companies in industries such as automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media, and retail. (Source: “RCD Profile,” Yahoo! Finance, last accessed May 17, 2013.)

With all this said, investors should keep in mind that consumer confidence is certainly a good sign for the U.S. economy, and it seems to provide the direction of the stock market—but correlation is not causation. Investors should always manage their risks and not get over-invested in one sector or asset class.

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