In the United States, consumer spending accounts for the majority of the country's economic output (more than two-thirds of GDP). If households are confident in the economy, they will spend more and invest more, which will in turn stimulate the economy, it's a virtuous circle. If, on the other hand, households are pessimistic, they will be more cautious about spending and businesses should make less profit.

This indicator is compiled from a survey of approximately 500 consumers. They are asked about their vision of the economic future in the short (1 year) and medium (5 years) term, about business and purchasing conditions, and about the health of their personal finances.

Some of the questions asked in this survey are:

  • Would you say that business conditions are better or worse now than they were a year ago?
  • Do you think that a year from now your household will be better off financially, worse off, or about the same as today?
  • What do you think will happen to interest rates for borrowing money over the next 12 months?
  • Will they go up, stay the same, or go down?
  • Over the next 12 months, do you think prices, in general, will go up, or down, or stay where they are now?

The Michigan Consumer Confidence Index (MSCI) was set at 100 when it was created on January 1, 1960 (it was actually created much earlier, in 1940, by Professor George Katona, but reliable data have only been available since 1960). Since then, it has varied from a high of 110.1 in March 2000, at the height of the dotcom bubble, to a very recent low of 53.2 in 2022.

Indeed, on August 1, 2022, the index reached an all-time low of 53.2. In other words, pessimism was at its worst, worse than during the subprime crisis in 2008 (low of 57.7 on December 1, 2008) or the second oil shock in 1979 (low of 53.6 on May 1, 1980)

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Source: Surveys of consumers - University of Michigan

Let's now look at the correlation with the S&P 500, the broad U.S. index. What did it do after the peaks of optimism and the peaks of pessimism over the following months and years?

To do this, I measured the performance of the S&P 500 following the ten worst peaks of pessimism (index < 60) and ten strongest peaks of optimism (index > 105) in the University of Michigan's consumer confidence index. I looked at the return on investment after 6 months, 12 months, 18 months, 2 years, 3 years, 5 years and 10 years.

Here are the results :

Source: MarketScreener

Notice the same thing I did? The bottom of the table is rather red (optimistic peaks) while the top of the table (pessimistic peaks) is rather green. Indeed, the S&P 500 index has performed very well in the months and years following a very low US household confidence index (< 60), while the US stock market has performed poorly. stock market performed poorly (and among the worst in modern history) after the consumer confidence index was very high (> 105).

Here's what it looks like on a chart of the S&P 500 since 1970. By buying fear (index < 60, green arrows) and remaining cautious (or selling) greed (index > 105, red arrows), you would have vastly outperformed the S&P 500 and would have entry and exit points that are quite relevant over the long term.

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Source: MarketScreener

There is another index to measure consumer confidence: The Consumer Confidence Survey published by the Conference Board. The mechanics are the same and the conclusions are similar to the previous Michigan index. It is better to "buy fear and sell greed" as Warren Buffett says. Historically, when consumer confidence has been high (as in 1999-2000), the S&P 500's performance in the following five years has been modest. And when confidence has been low, the return on the S&P 500 in the following five years has been high. The more pessimistic the public is, the greater the medium-term potential for stocks

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Source: The Conference Board

This is actually quite easy to explain. When the consumer confidence index is high, the market is comfortable with the future. Consumer expectations are high in a "blue sky" economy and investor expectations are high related to upcoming corporate releases. The market is therefore generally "expensive" at this time, and sentiment is high (on the surface).

We observe a correlation between the market's price (measured here with the S&P 500 P/E ratio) and the level of pessimism or optimism:

Sources: Yardeni & University of Michigan

And then suddenly, a cloud appears: a virus, a war, a recession, inflation, corporate bankruptcies. And the market realizes that the future will not be as bright as hoped. The market is not, however, more risky because you have suddenly become aware of a risk. The market is always risky, uncertain and unpredictable. The risks were there before, but sometimes they materialize and the market becomes aware of them, causing stock market indices and consumer confidence indices to fall. I like to say that "real risk is high when perceived risk is low and real risk is low when perceived risk is high". I think this sentence sums up what I wanted to show in this article.

François Rochon, another manager I admire, said in his annual letter to shareholders of Giverny Capital in 2010: "If I were a macro-economic strategist and I could only receive one piece of economic data per year to try to predict the stock market in the short or medium term it would be this one! It's simplistic without a doubt, but when consumers are pessimistic, the stock market is low and opportunities to get rich are numerous. When they are optimistic, the stock market is high and a little break is probably coming."

You won't be rewarded any differently than the market if you act in concert with the crowd. You have to stand out, rise up, and sometimes be contrarian with the many. You are not right or wrong because others agree or disagree with you. You are right when your reasoning eventually proves to be right. In the world of stock market investing, courage becomes the supreme virtue once you have enough judgment and knowledge. So let's act accordingly.