This is because there has for years been a close correlation between consumer sentiment and the All-Share index. Looking at annual changes since 1990 in the University of Michigan's measure of sentiment and in the All-Share index, the correlation has been 0.49. This is high, given how volatile both series have been in this time. This tells us that the old cliché is true - what's good for Main Street is indeed good for Wall Street.
From one perspective, this is surprising. New York University's Sydney Ludvigson and colleagues have shown that the biggest reason for the rise in share prices since the 1980s has been that incomes have shifted from wages to profits; it's no accident that the S&P 500 has hit record highs this year whilst median household incomes have fallen for years. This implies there should be a negative correlation between consumers' sentiment and share prices.
There is, though, a simple solution to this apparent paradox. It's that the drivers of equity returns in the short term - up to several months - are not the same as the drivers in the long-term. The weather is not the same as the climate.
In the short term, equity returns depend upon changes in risk appetite and in near-term growth expectations. This generates a co-movement between shares and consumer confidence because the same economic growth (and expectations thereof) which boosts corporate earnings and appetite for risk usually also raise wages and job security.
You might object that there's another explanation - that changes in share prices themselves cause changes in consumer confidence. One fact, though, tells us that this is not the whole story. This is that there's a stronger correlation between lagged changes in confidence and changes in share prices than there is between lagged changes in share prices and changes in consumer sentiment. This implies that consumer confidence leads share prices more than shares lead consumer confidence.
This hints at an intriguing possibility. Maybe equities underreact to the news about future economic conditions which is embedded in swings in consumer confidence. The idea that investors are clever and consumers silly owes far more to the narcissistic self-love of so-called experts than it does to the hard facts.
Herein lies a reason for optimism. Although US consumer sentiment has risen this year, the All-Share index has not. There are, of course, many reasons why this might be. One underrated one, though, is that equity investors might be under-estimating the extent to which the US economic outlook really has improved. If this is the case, then shares could rise in the next few weeks to the extent that investors cotton on to what consumers already know.
