Last Updated on September 19, 2022 by Quantified Trading
Consumer confidence tries to gauge the temperature of the economy. It swings from pessimism to optimism – just like Mr. Market who is rather manic-depressive. In the US it’s made by the Conference board and it casts doom and gloom on a monthly basis.
Consumer confidence measures optimism (or lack of optimism – pessimism) in the overall economy. Backtests reveal that when consumer confidence is bullish the stock market performs much better than when consumer confidence is bearish.
This article explains what consumer confidence is and at the end, we perform two backtests: one backtest showing that stocks perform well when consumer confidence is bullish, and a second test showing that stocks perform poorly when consumer confidence is bearish.
Before we go on to explain what consumer confidence is and how it’s calculated, we go straight to our backtests and look at the relationship between stocks and consumer confidence:
Consumer confidence and stock market returns – backtests
Let’s look at how stocks perform when consumer confidence is high and low to see if we can find any patterns.
In our backtests, we use US consumer confidence data from the database of OECD and not the specific data from the US Conference Board (see more below).
OECD collects consumer confidence data for all major countries that are published at the end of every month. OECD’s data varies slightly from the US version. The data we use in the backtests below are specific consumer confidence for the US economy (and not OECD overall).
In the graph below we show both the performance of S&P 500 (SPY) and OECD’s consumer confidence from 1993:
The blue line is consumer confidence (right axis) and the red line is S&P 500 (left axis and logarithmic scale). Clearly, consumer confidence seems to move down before the stock market heads down. Is this visual observation correct? Let’s test and finds out.
Consumer confidence and stock market returns – backtest 1
Our first backtest looks at the following:
- We make a 12-month simple moving average of consumer confidence.
- When the last monthly consumer confidence reading is above the 12-month moving average, we are long S&P 500 for the next month.
- When the monthly consumer confidence report is lower than the 12-month moving average, we switch to cash for the next month.
- Rinse and repeat.
The equity curve looks like this:
We invest 10 000 in two hypothetical strategies in 1993: buy and hold (red line) or only being invested in S&P 500 when consumer confidence is above its 12-month moving average. Buy and hold ends up with 159 000 while our strategy has 99 000 USD 28 years later.
The CAGR for buy and hold is 10.4% while our consumer confidence strategy has a CAGR of 8.4%. Considering that the max drawdown is substantially lower for the consumer confidence strategy (23%) than for buying and holding (55%), we would say our strategy looks decent. Additionally, our strategy is only invested 55% of the time. Thus, you might generate additional returns when the strategy switches to cash.
Consumer confidence and stock market returns – backtest 2
Let’s turn the backtest upside down and test the opposite signal: we are only invested in stocks when consumer confidence is below its 12-month monthly average. The equity curve looks like this:
A 10 000 investment in 1993 is only worth 15 000 28 years later – a miserable annual return of 1.58%.
What is consumer confidence?
Consumer confidence, which is measured by the Consumer Confidence Index (CCI), can be defined as the degree of optimism that the consumers pose in the state of the economy through their activities like saving and spending.
The CCI is put out by The Conference Board and serves as a measurement of the pessimistic or optimistic outlooks of the investors or consumers toward the economy with respect to the near future.
The CCI works on a simple concept which is that if consumers are optimistic about the economy, they will end up purchasing more goods and services, which will stimulate the economy consequently. On the other hand, if the consumers are pessimistic, then the sales of goods and services will plummet, weighing down the economy subsequently.
What determines consumer confidence?
The Conference Board carries out a survey of 5,000 U.S. households every month. Consumer confidence is determined by the following five questions in this survey:
- Participants’ evaluation of the current business conditions
- Participants’ evaluation of the current employment conditions
- Participants’ expectations about business conditions six months down the line
- Participants’ expectations about employment conditions six months down the line
- Participants’ expectations about their total family income six months down the line
The participants in the survey are asked to answer every question as positive, negative, or neutral. Pretty simple and straightforward.
While index changes of less than 5% are usually dismissed as insignificant, a change of more than 5% indicates a shift in the economy’s momentum.
While a month-on-month decreasing trend shows that consumers and investors have a negative perception of the economy, a rising trend in consumer confidence is indicative of improvements in consumer purchase patterns.
Consumer confidence is an important economic indicator as it helps traders and investors gain a broader understanding of the consumers’ view of the economy while also keeping track of the inflation possibilities.
Since weak consumer confidence reflects a decline in consumer spending, manufacturers will end up decreasing their inventories in advance. They could also delay any further investment in new projects.
Consequently, banks will start preparing for a reduction in lending activities like credit card use and mortgage lending. Eventually, the government will also get ready for a decline in future tax revenues.
On the other hand, improved consumer confidence will drive manufacturers to boost production and inventories and also encourage large employers to boost hiring rates. With an increase in consumer confidence, spending and risk-taking also tend to increase, thereby, resulting in overall bullish market sentiment.
The consumer confidence index is mainly dependent on the present situation index and the expectations index. People participating in The Conference Board’s survey are asked questions from these two indices. These indices involve the following metrics.
Present situation index:
- Evaluation of the current business conditions
- Evaluation of the current employment conditions
- Expectations about business conditions 6 months later
- Expectations about employment conditions 6 months later
- Respondents’ expectations about their total family income 6 months later
What are good and bad consumer confidence readings?
Contrary to what many feel, there are no ideal consumer confidence readings and any positive or negative reading depends primarily on the shift from the previous reading. It is because of the dynamic nature of consumer confidence, which keeps changing every month.
However, if we were to analyze the efficacy of the consumer confidence index, it would be safe to state that a change of less than 5% in the consumer confidence index is usually deemed insignificant. On the other hand, a shift of more than 5% in the consumer confidence index is indicative of a change in the economy’s momentum.
What is Michigan consumer sentiment?
The Michigan Consumer Sentiment Index is a monthly survey of consumer confidence levels in the United States conducted by the University of Michigan. The survey is based on telephone interviews that are conducted to gather information on consumer expectations for the economy.
Professor George Katona of the University of Michigan’s Institute for Social Research devised the Michigan Consumer Sentiment Index in the 1940s. His efforts resulted in the institution conducting and publishing a national telephone poll on a monthly basis. The study asks consumers about their personal finances as well as the short- and long-term status of the economy in the United States.
The preliminary report, which contains survey results received in the first two weeks of the month, is usually released in the middle of the month. The final report, which covers the entire month, is released at the conclusion of the month. It aims to convey the atmosphere of American shoppers. Whether the mood is upbeat, downbeat, or neutral, the survey provides insight into consumer spending plans for the near future.
Consumer confidence and stock market return – backtest conclusions
Our backtests reveal pretty clearly that consumer confidence is an important factor in predicting future stock market returns. When consumer confidence is above its 12-month moving average, it’s wise to be invested in stocks, Opposite, when consumer confidence is below its 12-month moving average, the stock market performs poorly.