How clever is the average American? If your answer involves Homer Simpson or George Bush, you've made the mistake of confusing an average with a stereotype. In one respect at least, the average American is much cleverer than the stereotypical one. And this has worrying implications for investors.
Our chart shows the point. It shows that the ratio of consumer spending to households' net wealth has been a handy predictor of equity returns. When spending has been high relative to wealth - for example in 1985 and 2003 - shares subsequently did well. And when spending has been low relative to wealth - 1987 and 2000 - shares subsequently did badly.
Economists now pretty much agree that the ratio of spending to wealth (or variants thereof) have predicted returns in the past; no-one, of course, can say it'll do so in the future. This was first pointed out by Sydney Ludvigson and Martin Lettau, (click for a PDF of their report, Consumption, Aggregate Wealth and Expected Stock Return), two US academics, and it's been corroborated recently by Anne-Sofie Reng Rasmussen of Aarhus School of Business (click here for an abstract of her report).
There's a simple reason for this. If people see good times coming, they'll increase their spending in anticipation. So a high spending-wealth ratio will lead to good returns. And if they see bad times coming, they'll hunker down beforehand.
Of course, it needn't be equity returns that consumers anticipate directly. Maybe they anticipate booms and slumps in economic activity or in house prices, and equity returns are correlated with these.
You might object here that consumers aren't clever enough to foresee good and bad times. After all, if economists can't do so, why should the common herd?
Two reasons. First, each individual knows a little about the prospects for his own occupation, area or industry. When added together across millions of people this local, fragmentary, tacit knowledge far exceeds the knowledge available to economists.
Secondly, individual errors cancel out across millions of folk. Sure, many are irrationally optimistic. But this is offset by others being irrationally gloomy. On balance, the average American is much smarter than the typical one.
This matters now because the consumption-wealth ratio is well below average, suggesting consumers are anticipating bad times and poor equity returns.
Which raises a challenge for any bull. Why might consumers be wrong now? What do you know that they don't?
