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Sales warning

Retail sales predict share prices. And right now, they're pointing to mediocre returns.
August 23, 2018

High-street spending has begun to perk up. Last week’s official figures showed that retail sales volumes in July were 3.5 per cent up on a year ago. If such growth can continue, all equity investors should rejoice, even if they don’t own retailing stocks.

My chart shows the point. It shows how the ratio of retail sales to the All-Share index has predicted annual changes in the All-Share index in the following 12 months. A high ratio of sales to the index leads to shares rising, and a low ratio to them falling. Since current official data on retail sales began in 1996, the correlation between the two has been 0.47. It has, however, been especially close in recent years.

There have only been two notable occasions since 2000 when the ratio failed to predict returns. One was in 2002-03 when shares continued to drop as the tech bubble deflated. The other was in 2008; the financial crisis came as a surprise to shoppers as well as everybody else. Even then, however, the ratio predicted that shares would fall; they just fell by even more.

Strong spending (relative to share prices) therefore leads to share prices rising, while weak spending leads to them falling. There are two reasons why this is the case.

One is that share prices sometimes over-react; they occasionally fall too far or rise too much. When they do, the ratio of share prices to any stable-ish upward-trending variable will tell us that prices are out of kilter and so subsequently correct themselves. The ratio of prices to retail sales, dividends, the money stock or even a simple time trend will then be able to predict returns.

But there’s something else. It’s that consumer spending depends at least in part upon expectations. If you expect a big pay rise you’ll spend more than if you expect to lose your job. Economists call this the permanent income hypothesis – which is a 10-bob phrase for a two-bob idea.

From this perspective, retail sales data are a simple measure of expectations, They work in the way that Friedrich Hayek thought that a well-functioning price system operates – as a simple way of summarising millions of bits of fragmentary, dispersed information held by countless people.

High retail sales relative to share prices are therefore a sign of better times to come and hence rising share prices – such as in 2003 or 2009 – while low sales relative to prices are a portent of bad times and hence of falling prices.

This, of course, is not a new insight. All I’m doing Is echoing older research. In the US, Sydney Ludvigson and Martin Lettau have shown that more sophisticated measures of the ratio of consumer spending to wealth predict share prices, whilst Bank of England research has found a similar thing to be true in the UK.

This might seem common sense. But it has a radical implication – that ordinary people collectively sometimes have better insights into the future than so-called experts. Under some conditions, there really is wisdom in crowds.

Sadly, however, right now this is not good for investors. Despite their recent rise, retail sales are moderately low relative to the All-Share index. The ratio of the two is slightly below its long-term average. This points to below-average returns – to a rise of just over 2 per cent in the All-Share index by June 2019 if we are being overly precise, or to an almost 50-50 chance of the market falling if we are less precise but more accurate.

You might object here that retail sales are low not because people are pessimistic but because real wages have been flat for years and so people cannot spend much more.

In theory, such as objection makes sense. If it were correct, however, one would expect the relationship to have broken down in the months after the financial crisis, when credit constraints were squeezing spending. But that didn’t happen.

Of course, this doesn’t rule out decent returns simply because there is statistical noise in this relationship as there is in all others in economics. Even if the past relationship continues to hold, there’s almost a 30 per cent chance of shares rising more than 10 per cent in the next 12 months.

This, however, is not the only lead indicator we have. There are others such as the ratio of share prices to the money stock in the developed world, foreign buying of US equities or ratio of Aim shares to FTSE 100. All are telling us much the same thing – that prospects for returns are lacklustre. Not disastrous, but dull. Should we really ignore all this?