We’re having a consumer boom. Official figures show that retail sales volumes rose 1.6 per cent in the first quarter. This reminds us that retailers’ problems are about margins and some companies’ specific troubles rather than about aggregate growth.
Such growth is great news for equity investors. This isn’t simply because the consumer is the only thing keeping us out of recession. It’s also because retail sales tell us that the medium-term outlook for equities is good.
There’s a simple reason for this. Consumer spending is partly forward-looking. If we expect a pay rise we are more likely to spend than if we fear getting the sack. Of course, any particular consumer might be wrong or irrational. But across millions of us such errors often cancel out. There is wisdom in crowds. And this means that high consumer spending predicts good times.
Better still, the dispersed fragmentary insights into the future that consumers have are not discounted by equity investors, who tend to listen too much to men in suits and not enough to ground truth. Which means that consumer spending predicts share prices.
This was first pointed out by Sydney Ludvigson and Martin Lettau for the US in 2001, and was corroborated by Bank of England research later. Although they use fancy econometrics, simple statistics tell the same story. There’s a strong positive correlation between the ratio of retail sales to the All-Share index and subsequent changes in the All-Share index: it is 0.47 for annual changes and 0.76 for three-yearly ones since 1996 (when the current vintage of retail sales data begins). There’s also a high correlation between the ratio of retail sales to house prices and subsequent three-year changes in house prices. It is 0.49 for annual changes and 0.71 for three-yearly ones.
Now, you might object here that these correlations, strong as they are, don’t prove that consumers help predict future share prices. They might merely tell us that the market overreacts. Sometimes shares rise too much, which pushes down the retail sales-price ratio and also leads eventually to prices falling. A ratio of share prices to any stable-ish upward trending variable – even a simple time trend – would then also predict returns.
For practical purposes, however, we don’t need to debate this. The fact is that ratios of retail sales to share prices and house prices predict future returns on both.
Which is where the good news comes in. The rise in retail sales means that their ratio to the All-Share index is now slightly above average. This points to above-average rises in the index over the next 12 months and three years. Granted, this is only a weak signal. But it corroborates other bullish signals such as the low dividend yield or big foreign selling of US equities.
Things are not so cheery for house prices, however. Although the ratio of retail sales to house prices has risen since 2016-17 it is still below its post-1996 average. Which points to below-average changes in house prices in coming months.
All this corroborates something I said recently, using a different perspective – that the outlook for equities is rather better than that for house prices.
