One feature of the past 12 months, and a big reason why GDP growth was stronger last year than economists expected, was the strength of consumer spending. Next week’s numbers might confirm this. Official figures on Friday are expected to show that retail sales bounced back in January after a weather-induced fall in December, and that sales volumes are up by around3 per cent on a year ago.
With real wages falling, people have financed this spending by dipping into their savings or borrowing more: the household savings ratio last year probably fell to its lowest rate since the late 1950s. This has prompted some talk that shoppers have been irrationally overoptimistic. I suspect, though, that in aggregate they are neither.
I say so because of the ratio of retail sales to the All-Share index. It makes sense to compare the two because they are both, in theory, forward-looking. Consumer spending should depend on people’s ‘permanent’ income – their lifetime prospects. And share prices should be a claim upon future profits. Both, then, should be indicators of sentiment about the future.
And here’s the thing. The ratio of retail sales to the All-Share index in December was slightly below its average since 1996, when current sales data began. This tells us that far from being overoptimistic, consumers are actually more pessimistic than stock markets.
This ratio also tells us that consumers are more rational than stock markets. I say this because this ratio does a better job of forecasting moves in share prices than it does of forecasting retail sales. The correlation between the ratio and subsequent returns on the All-Share index has been 0.76 for three-year changes in the All-Share since 1996. Low ratios of sales to the All-Share index in 1999 and 2006-07 led to falling share prices, for example, and high ratios in 2003 and 2009 led to rising prices. The correlation between the ratio and subsequent three-year changes in retail sales is, however, much weaker: it’s been only minus 0.29 since 1996.
This tells us something. It tells us that stock markets are prone to overreact; they got too high in the late 1990s and in 2006-07 and too low in 2003 and 2009. Consumer spending, by contrast, was much less prone to overreactions.
Of course, this doesn’t prove that consumers are wholly rational. But it does suggest they are less prone to one particular form of irrationality than are stock markets.
Across millions of consumers, irrationalities often largely cancel out: for everyone who’s a daft spendthrift, someone else is overly cautious. Across investors, however, this is not so assured. Sometimes, peer pressure and contagion cause optimism (or pessimism) to spread and intensify, driving share prices too high (or too low). Consumers, then, are often emergently more rational than investors.
Right now, this is warning us to be cautious of equities: a below-average ratio of retail sales to the All-Share index predicts below-average returns on the latter, at least over the medium term. In itself, this is not alarming; it’s only very slightly below average. But it’s consistent with other indicators, such as the global money-price ratio and foreign buying of US equities, which also point to poor returns.
