Misplaced confidence?

US consumer confidence is very high. Our analysis suggests this is not good news for investors in equity markets.
The Green Line
Bertie Dannatt
Investment Director

The chart above links US consumer confidence and returns from the US stock market. It shows that in periods when consumer confidence is high, the subsequent returns from US equities over the next five years tend to be low or negative.

Where are we today? The latest reading from the Conference Board’s US consumer confidence indicator was 125.4 – putting it in very high territory. If the historical pattern is repeated, returns on the US equity market will be negative over the next five years.

It may seem strange that investment returns should be poor after periods when confidence is at its highest. The underlying logic is that when consumers are upbeat, they are spending money freely, pushing up companies’ turnover and profits. This economic confidence boosts investor confidence, pushing up the valuations of stocks. This is a classic feedback loop.

Alas, ever-rising confidence cannot continue forever. Sooner or later, something happens to dampen the mood – perhaps rising interest rates. Consumers then spend less, and companies make less money. Investors are disappointed by the fall in today’s profits; they also discover that the valuation they placed on future profits is too hopeful. Returns from the stock market become disappointing, and this can prompt further selling of equities. This, too, is a classic feedback loop.

As absolute return investors trying to deliver positive returns in all market conditions, we are sensitive to the warning signs that a chart like this shows. In order to preserve and grow our clients’ capital we are always looking out for things that seem too good to be true.

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Chart source: Ruffer LLP. S&P 500 index and Conference Board consumer confidence.

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