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.)
With this in mind, it’s a worrisome data point. While it is great that people are feeling more confident, confidence has an upper bound, and it will inevitably turn lower. Since confidence is closer to a peak than to a trough, by extension we can make a similar claim about the stock market and economic activity. We have, in fact, already seen economic activity begin to decline as Q1 GDP contracted by nearly 3 percent.
Therefore, investors should be extremely careful in the stock market at this stage in the ascent. While things look pretty good right now, investors tend to be overpaying for stocks, which trade at a 50 percent premium to historic averages. Investors should look for selling opportunities for overvalued stocks. They should also, however, look for buying opportunities in undervalued stocks, and there are plenty still out there if you look hard enough and under the radar.
More generally, investors should take this time to clear up their personal balance sheets. While stock prices are high and while people are confident in their incomes, this is a great time to pay down debt and to start pulling back. While this seems counterintuitive if you are earning more money, you should make sure you are prepared for a rainy day. Again, the economy is cyclical and recessions occur every few years. With the lousy Q1 GDP data we may already be in one, and if we aren’t then we are closer to the peak of the expansion than to the beginning.