One Step Forward, Waiting for Two Back

10/31/2011 8:15 am EST

Focus: MARKETS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

Last Thursday’s news about the plan to fix the European debt crisis was a big boost to the market. But there’s a long way to go before investors’ psyches will be healed, writes John Reese of the Validea Hot List.

The Europe problems, rampant fears of a "double-dip" recession that doesn’t seem to be materializing, and the lingering effects of the 2008-2009 financial crisis and market plunge have all made for a very pessimistic climate, both in terms of the economy and the market.

From June through September, for example, investors pulled more than $111 billion out of stock and mixed-equity mutual funds and exchange traded funds, according to Lipper Analytical Services.

A lot was also made this past week about the latest consumer-confidence figures, as the Conference Board’s consumer confidence index fell in September to its lowest level since March 2009. And, to be sure, there’s a lot to be worried about.

While corporations’ earnings have been booming since the end of the Great Recession, average workers haven’t gotten nearly the same benefit. Many haven’t been able to find jobs at all, with the unemployment rate still up over 9% more than two years after the recession ended.

But the leap that many pundits seem to make is that the weak consumer-confidence numbers portend a poor holiday shopping season, and poor stock-market performance. I think there’s a good chance both predictions are off base. In fact, the current pessimistic environment may be setting up a pretty bullish environment for investors.

Why might consumer spending be better in the coming months than many expect? A couple reasons. First, the troubles surrounding Europe have not only depressed the stock market in recent months; they’ve also caused major declines in commodity prices.

Gasoline prices are down 12.7% since their May highs, for example, while the United Nations’ food price index has fallen in each of the past three months. That translates to more money in consumers’ pockets, which may make for some upside surprises in consumer spending this holiday season.

In addition, consumer confidence has been low for a while now—in fact, it hasn’t risen above "normal" levels at any point during the recovery. And yet consumer spending has jumped significantly during the post-recession months.

According to the Commerce Department, retail and foodservice sales are now 19% higher than they were at their 2009 recessionary low, and 4.5% higher than their pre-recessionary high. And that’s happened with consumer savings rates considerably higher than they were leading up to the recession.

I would submit that consumer confidence having remained low during the recovery—and tumbling even lower in recent months—is as much about the depth and breadth of the last recession as it is about facts. The Great Recession was so steep that it had an impact on Americans’ psyches that won’t be undone in a matter of months, or even a year or two.

It’s what Wells Capital Management’s James Paulsen has termed, "post-traumatic-armageddon-hypochondria"—any hints of trouble make investors and consumers flash back to 2008, and they fear the worst, even though they’re in much better position than they were in 2008.

It’s thus not surprising that there’s been a big disconnect between how consumers say they feel (i.e. very scared), and what they’re actually doing with their money (i.e. spending it).

Just as importantly, keep in mind that periods of high pessimism are often followed by strong gains for the market. That’s because people, being emotional creatures, are prone to overreaction. When they realize that the reality isn’t as bad as their fears, a sense of relief hits, and many investors come rushing back to the market.

NEXT: On the Contrary

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There is hard data to support this. One study, performed by money manager Kenneth L. Fisher—one of the gurus upon whom I base my strategies—and finance professor Meir Statman found that months in which consumer confidence was low tended to be followed by months in which stock returns were high, particularly for small-cap and Nasdaq stocks.

"Consumer confidence declines when stock prices decline, but investors need not fear that declines in consumer confidence would be followed by low stock returns," Fisher and Statman wrote. "Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns."

Liz Ann Sonders of Charles Schwab also presented some interesting data on consumer confidence and stock-market returns earlier this year. Looking at data from the Conference Board and Ned Davis Research, Sonders found that, going back to 1969:

  • When the consumer-confidence reading has been above 110, the stock market has gone on to lose 0.2% per annum;
  • When the reading has been between 66 and 110, the stock market has averaged 6.4% per annum gains;
  • And when the reading has been 66 or below, the market has gone on to gain 14.9% per annum. (The most recent monthly reading for the index was just under 40.)

"Much like investor sentiment, which works its contrarian magic on stocks, the same can be said for weak consumer confidence," Sonders wrote in commentary on Schwab’s site. "The best performance for the stock market has historically come when consumer confidence was its weakest. Remember, consumers are generally reactive, while the stock market looks ahead."

Of course, as with anything in the stock market, there is never a silver bullet, and the low consumer sentiment numbers don’t mean that the market is going to take off today or tomorrow. And it certainly doesn’t mean that the market is going to head upward in a straight line.

But it does mean that the low consumer confidence readings are not reason to be alarmed, and they are not reason to flee the stock market. In fact, it may be the opposite.

We saw what happened this week when the gloom and doom surrounding Europe cleared a bit. If that continues to happen, investors may finally start to focus on the fact that US economic data has been better than many have been predicting.

And that’s when we could really see some major gains for the market—particularly for the type of fundamentally sound, undervalued stocks we pursue.

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