It’s time to buy UK equities. This is the message from consumers.
I say so simply because official figures tell us that retail sales have hit a record high, which means that the ratio of sales to the All-Share index has risen to an 11-year high.
Which is fantastic news as this ratio has been an extraordinarily good predictor of equity returns. Since current sales data began in 1996, the correlation between this ratio and subsequent three-year changes in the All-Share index has been 0.75 – which is astonishingly high by the standards of macroeconomics. Low ratios of sales to share prices in 2000 and 2007 led to nasty bear markets, while higher ratios in 2003 and 2009 led to great rises.
This ratio is now predicting a great rise in prices in the next three years.
One reason for this is that share prices over-react – they get too high and too low. This means that the ratio of the All-Share index to any stable upward-trending variable will to some extent predict returns – be it the ratio of share prices to dividends, the money stock, GDP or even a simple time trend.
But there’s another reason. Consumer spending is forward-looking. If we expect better times we will spend more whereas if we fear losing our job we will tighten our belts. This is Milton Friedman’s permanent income hypothesis. Although this theory isn’t precisely true – spending is more sensitive to current income than the theory predicts – there is enough in it to make aggregate spending a decent predictor of equity returns. This fact was first unearthed in the US by Martin Lettau and Sydney Ludvigson, and Bank of England economists have corroborated it in the UK.
You might object to this that consumers are irrational and can’t successfully look ahead. Not so. Across millions of consumers, errors often cancel out: for anyone who is wrongly optimistic, somebody else will be wrongly pessimistic. Aggregate consumer spending therefore does what Friedrich Hayek claimed that the price system does: it collects together fragmented, dispersed (and often inarticulable) knowledge into a single metric that contains better information than any single mind can possess.
Which poses the question: will this past relation continue to hold?
You might object that the Office for National Statistics' (ONS) measure of sales doesn’t reflect the grim reality on the high street: next week’s Confederation of British Industry (CBI) survey will report yet more weakness here. Their survey, though, under-samples online sales – but these matter as a gauge of how consumers feel.
You might also object that consumer confidence is weak: next week’s GfK survey will show it only slightly above lockdown lows. However, people are much more optimistic about their personal financial situation than about the general economy. And this is what matters: they know something about the former but diddly-squat about the latter.
Instead, there’s another problem. It’s that retail sales might be unsustainably high. They were inflated in July by the release of demand that had been pent-up by the lockdown and by the fact that we have spent more in shops because we’ve not gone to pubs, restaurants and cafes as much as we used to. On both counts, the official measure of sales could slip back.
But even if we assume a big drop in sales – of, say, 10 per cent – the ratio of sales to the All-Share index is still well above its long-run average. Which points to above-average returns. What would jeopardise this would be if we all get a nasty surprise such as a serious second wave of the virus. Subject to this caveat, though, shoppers are telling us to buy equities now.
