There's growing evidence that consumer spending can forecast share returns. A recent paper by Paul Gao and Kevin Huang, two US economists, has found that deviations of spending from its long-term relationship with wealth and labour income can forecast All-Share returns in the following three and 12 months.
This follows earlier research by Bank of England economists, which found that over a quarter of the variation in annual equity returns can be forecast by such deviations.
It seems, therefore, that the original findings of Sydney Ludvigson and Martin Lettau for the US apply to the UK, too.
This is worrying, because consumer spending is now low relative to wealth. It's at a 30-year low relative to house prices, and is only around average compared with net financial wealth or disposable incomes (a proxy for the dividend on human capital). This points to poor returns on shares - albeit not as bad as in 1999-2000, when consumer-wealth ratios were much lower.
There's a simple reason why spending should predict returns.
In the long run, spending and wealth should rise in line. If they didn't, we'd all end up either as spendthrifts with no money or like Scrooge McDuck: rolling in cash but spending nothing. This is silly.
But if the two rise in line in the long run, what happens after spending is low relative to wealth? Either spending will rise or wealth will fall.
In practice, it seems to be wealth that falls. In theory, it could be human capital or house prices that take the strain rather than share prices. But, in practice, this is not the case.
The bottom line is clear. Theory and evidence say that spending can predict returns - more so than can some 'orthodox' valuation measures. Why, then, do the experts ignore it?
