Economists have long been worried that the UK’s recovery has been too consumer-led. From an equity investors’ point of view, however, such worries are wrong. The pick-up in consumer spending – insofar as we’ve had one – is a good thing.
I say so for a simple reason. For years, there’s been a strong link between the ratio of consumer spending to share prices or house prices and subsequent real returns on equities. When spending has been high relative to asset prices, equities have done well in the following three years, and when spending has been low, shares have subsequently fallen. Low ratios of spending to share or house prices in 1987, the late 90s and in 2006-07 all led to shares falling. Since 1984 the ratios of consumer spending to house and share prices have explained (statistically speaking) over three-fifths of the variation in three-yearly real returns on the All-share index.
It’s not just in the UK that this has been the case. Sydney Ludvigson and Martin Lettau have shown that the same is true in the US.
There are two reasons for this.
One is simply that shares tend to overshoot on both the upside and downside. This means that the ratio of shares to any stable-ish upward-trending time series will have some predictive power.
This, though, isn’t the whole story. It can’t explain why the ratio of consumer spending to house prices also helps predict equity returns. Something else, therefore, is going on.
To see what, remember basic common sense – that our spending decisions should be future-oriented. If we expect our income to rise or our job to be safe, we’ll spend more than if we fear a drop in income or unemployment. This means that if consumers anticipate good times, spending will be high.
But won’t share prices be higher too? Not necessarily. Millions of consumers don’t invest in shares so their optimism doesn't directly raise shares. And it’s possible – given the complexity of the economy – that the information feeding into share prices will be a biased subset of all the fragmentary, tacit and dispersed information that millions of people have about the future. Sometimes, therefore, consumers’ sentiment will differ from investors’ sentiment. When it does, the gap between the two will help predict returns: when consumers are more optimistic shares will rise as the stock market catches up, and when consumers are more pessimistic shares will fall.
Of course, each individual consumer has all sorts of daft ideas about the future. But across millions of people the daftness largely cancels out. Insofar as it does so, consumer spending can convey information about the future that’s not in share prices.
Herein lies some good news for investors. Right now, the ratio of consumer spending to share prices is above its long-term average, which points to good returns. This bullish message is however slightly tempered by the fact that the ratio of spending to house prices is below its average. Nevertheless, if post-1984 relationships continue to hold, these spending ratios point to a total return on equities (including dividends) after inflation of around 36 per cent in the next three years, with only around a four per cent chance of a real loss in this period.
In this sense, the consumer-led recovery is a very good thing.
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Chris blogs at http://stumblingandmumbling.typepad.com