US consumers are still depressed. The Conference Board is likely to report next week that its measure of sentiment is well below its long-run average, despite signs of a pick-up in the housing and labour markets in recent months; in the last 12 months, employment has grown by 1.7 per cent and house prices have risen 4.3 per cent. This fact is surprisingly important for even the most parochial of UK investors.
I say so for a simple reason. For a long time there has been a good correlation between US consumer sentiment (as measured by the University of Michigan) and the dividend yield on the All-Share index: it has been minus 0.44 in monthly data since January 1985. Americans' attitudes towards their economy and investors' attitudes to the UK stock market have much in common. For example, low consumer confidence in the early 90s and in 2008 was accompanied by high dividend yields, and high consumer confidence in the mid-80s and late 90s by low yields.
This implies that sentiment has a large, common, global component. When Americans have faith in their economy, investors have faith in UK equities - and, in fact, in equities around the world.
This implies that if or when US consumer confidence improves, dividend yields should fall and so share prices will rise. Since January 1986, there has been a significant correlation (0.42 in monthly data) between annual changes in US consumer sentiment and total returns on UK equities. Rising consumer confidence is good for shares.
Better still, it suggests that the very fact that US consumer sentiment is depressed now is itself a bullish sign for shares. Just as low confidence, as measured by the dividend yield, leads to good equity returns, so too does low confidence as measured by US consumer sentiment indices. Since January 1985, there has been a significant negative correlation (minus 0.24) between US consumer sentiment and equity returns in the following three years. High sentiment (for example, in 2000) leads to poor returns, and low sentiment (for example, in late 2008) leads to rising share prices.
Sadly, however, there's a caveat here. US consumer confidence is now low relative to what you would expect given its historical relationship with the All-Share dividend yield. And this is slightly worrying. On some previous occasions when this has been the case, shares have subsequently done badly. For example, low consumer sentiment in 2001 and 2005-06, relative to dividend yields, led to shares falling in the following three years. The converse has also been true sometimes; high consumer confidence, relative to the dividend yield, in the mid-80s and mid-90s led to good equity returns.
This suggests that American households might be telling us something. The fact that they are more depressed than equity investors could be a hint that the economic outlook is worse than equity valuations imply.
Although it's easy to think of American consumers as being witless Homer Simpsons or Carrie Bradshaws, there is sometimes wisdom in crowds. Of course, any individual consumer will be wrongly pessimistic or wrongly optimistic but across tens of millions of people these errors might cancel out, with the result that aggregate consumer confidence can sometimes tell us something. By contrast, investors' sentiment is sometimes prone to herding and overreaction, which might cause share valuations to become too high or too low.
We can, therefore, use consumer confidence as a way of checking the sentiment indicated by equity valuations. If confidence is low, relative to the dividend yield, it warns us that perhaps the US economy is heading for disappointment and that equity valuations are too high. And, right now, this is what consumer confidence is telling us.
Now, this is no reason to rush out to sell shares. History shows that the signal from the gap between consumer confidence and the dividend yield, while statistically significant, is quite weak. Right now, it is mitigating the bullish message coming from the still-high dividend yield, rather than sending an outright bearish message. If the post-1985 relationship between three-year total returns on equities and the dividend yield and that part of US consumer sentiment unrelated to the dividend yield continues to hold, then the All-Share will give us a return (including dividends) of just under 7 per cent a year over the next three years. This is not great, but it's not catastrophic, either.
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Chris blogs at http://stumblingandmumbling.typepad.com