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The welcome consumer boom

I say this because of something first noticed by Sydney Ludvigson and Martin Lettau in 2001 but corroborated by Bank of England research and subsequent events. This is that consumer spending, relative to wealth, can predict equity returns. For example, high ratios of spending to the All-Share index or house prices in the mid-1990s, early 2000s and in 2009 led to high returns on the All-Share index in the following three years, while low ratios of spending to wealth in 1999 and 2006-07 led to falling share prices.

There's a statistical reason for this, and a behavioural one. The statistical one is that, over the long run, spending and wealth should rise at more or less the same rate: the two are cointegrated. If this were not the case, we'd either all end up eventually being infinitely wealthy but spending nothing or spending everything and having no wealth at all. Both are unlikely, at least in aggregate. This implies that if spending is high relative to wealth then either spending must fall or wealth rise. And the facts show it is at least partly the latter.

The behavioural explanation is that there is wisdom in crowds. Our spending depends in part upon our expectations for the future: if we're confident we're more likely to spend than if we're worried for our jobs and incomes. Of course, if we take any individual at random he is likely to be mistaken about the future. But across millions of people, these mistakes might well cancel out; for everyone who's mistakenly optimistic, someone else is wrongly gloomy. When the mistakes do cancel out, high aggregate spending will predict good economic times - and hence rising share prices - and low spending will predict bad times and falling prices. As Friedrich von Hayek said, the dispersed, fragmentary knowledge of millions of people is greater than that of any so-called expert.

You might object to this that the ratio of consumer spending to share prices predicts returns not because of anything consumers do, but simply because share prices sometimes overreact and fall too far or rise too much. When this happens, the ratio of prices to any stable-ish variable will predict subsequent returns.

Maybe. But this can't explain why the ratio of consumer spending to house prices also predicts returns. And it still implies that there's predictability in returns from the consumption-share price ratio - which is surely useful.

And herein lies the good news. The ratio of consumer spending to share prices is now above its post-1990 average - although thanks to sky-high house prices the ratio to the latter is below-average. If post-1985 relationships between these two ratios and subsequent returns continue to hold, then we should enjoy a total real return on the All-Share index of around 34 per cent over the next three years, with only around a 3 per cent chance of a loss. Investors, therefore, should welcome strong consumer spending.