Trader’s Narrative

Late last week we got the latest figures from the Reuters/University of Michigan survey. Consumer sentiment continues to recover with the preliminary June 2009 number at 69% - compared to 68.7% for May 2009. The consensus of economists was for a larger recovery but there is no doubt that US consumer sentiment is slowly recovering from the drubbing it got a few months back. Things were so extreme that we hadn’t seen such low consumer sentiment since 1980!

But there was another data point that got my attention from the Reuters/University of Michigan survey. There was an increase in the number of people expecting an increase in interest rates from 36% in May to 53% in June.

With those that expecting the opposite shrinking from 19% last month to just 10% now. This differential is the largest since August 2007 (red arrows in chart):

Keep in mind that bond yields and bond prices move inversely. So a fall in yield would be accompanied by higher bond prices.

As you can see in the chart, the red arrow doesn’t coincide exactly with the 2007 summer peak in yields but then again, if we go back we find that the chart consistently trends downwards. In fact we could look back 10, 15, 25 years and more and still find that yields in a downtrend. Of course within this macro-trend there have been some very sharp counter rallies - of which the early 2009 rally stands out.

The most recent consumer sentiment numbers from Reuters and the University of Michigan show an extreme pessimism. To be exact, in October, the “current conditions index” dropped to 91.0 while the “expected index” fell to 64.7 — the lowest since Hurricane Katrina.

We haven’t seen numbers like these since 2003 when the bear market gave way to the current bull market. Other than 2003, we’d have to go back 15 years to find a similar consumer sentiment reading.

Now that is extreme. And yet, from a contrarian point of view, comforting. That’s because consumer sentiment is a lagging indicator and by the time extreme pessimism has seeped into the masses, a new horizon shortly appears and the darkness is dispelled. Check out these graphs of the Michigan Consumer Sentiment and you’ll see what I mean.

According to a research study by Meir Statman, a finance professor at Santa Clara University and Kenneth Fisher of Fisher Investments:

Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns.

Although it is extremely difficult to go against the crowd, the best time to buy is when there is “blood on the streets”. With consumer confidence this low the retail sales could be a disaster — although you wouldn’t guess that from the crowds on Black Friday.

The technical indicators (new lows relative to new highs) are aligning and now sentiment is falling into place.