Does Surging Consumer Confidence Signal a Cyclical Peak?

Source: Thinkstock

Source: Thinkstock

Investors received some good news on Tuesday, namely that the University of Michigan’s consumer confidence survey yielded the best results in 7 years. The index came in at 90.9 versus 86.4 in June. A high reading in this index suggests that consumers feel more comfortable in their economic situation. They have enough money to buy the things that they want to buy, they are confident that their incomes will remain stable, and they are generally not worried about their finances.

When consumers are confident, they tend to spend more money, make major purchases (e.g. cars and homes), and make more discretionary purchases. So it shouldn’t surprise anybody that retail stocks, as measured by the SPDR Retail ETF (NYSEARCA:XRT), outperformed the market on Tuesday.

Now, you might be tempted to become more aggressive with your investments in light of this information. After all, if people are more confident in their personal financial situations, we should see earnings boosts for retailers, and this will have a ripple effect throughout the economy to benefit manufacturers, shippers, and American companies more generally. So it makes sense that these companies’ earnings will rise and so will share prices, right?

While this makes a lot of sense, keep in mind that the last time the index reached 90+ was in 2007, and 2007 was a great year to be selling stocks, not buying them. How can this be? The answer is that consumer confidence is cyclical — consumers go from being confident to being concerned to being confident again. As consumers become more confident, the economy tends to expand and stocks rise. When consumer confidence peaks, this tends to coincide with a peak in economic activity and the stock market. Similarly, as consumer confidence falls so does the stock market, and when consumer confidence troughs, this tends to coincide with a bottom of the stock market and in economic activity (remember how bad everybody felt in 2009.)