Trader’s Narrative

The big news today was that the University of Michigan’s Index of Consumer Sentiment fell to 79.0 in May from April’s final 87.4. This was far below the Wall Street forecast of 86.1.

A few basic facts:

To begin with, 79.0 is the ‘preliminary’ index of consumer sentiment. We’ll have to wait till the end of the month for the final number. The survey is conducted over the phone and includes 300 households for the preliminary numbers and 500 for the final one. Although the survey’s results are usually boiled down in the media as one number, the survey itself is far from monolithic. It covers a wide range of topics: buying conditions for houses, vehicles, large household goods, expected changes in unemployment, interest rates, inflation, etc. All the data is then standardized by using 1966 as the base year. Some critics question both the methodology of the survey and its small sample size. But one can’t deny that the survey has a large following and that it has been predictive in the past.

Going back to this month’s results, next to the Index of Consumer Sentiment, the Current and Expected numbers are the most watched. The Current index for May came in at a reading of 79. Putting that in perspective, it is the lowest such reading since 1993 - with one exception: the sentiment right after hurricane Katrina. As well, the 13 point, one month decline is the largest one month drop since 1978 (when the metric switched to monthly intervals).

In fact, searching history we see that sharp monthly declines of this magnitude, correspond directly with very cataclysmic events that shock people out of a state of complacency and into one of worry or outright panic. These examples include hurricane Katrina, as mentioned, the invasion of Kuwait by Iraq, and the Iranian hostage crisis in 1980.

The Expectations Index, which most people view as a leading indicator for the economy, fell to a preliminary reading of 68 from 73.4 (in April).

As you can see from the above chart, the Michigan survey can be used as a contrarian signal to time the market. But only with great care. Due to its nature, it should only be used as a tell for longer time horizons. Right now, the Michigan survey is saying that we are getting close to an inflection point similar in the past where the consumer has been nervous.

One has to be careful though, since sentiment can still go much lower from here. As you can see, the Current/Expectations Indices reached as low as the mid-40’s in 1974 and again in the early 1980’s.

Also, what we are seeing now is a bit of an anomaly since usually the low sentiment readings from the Michigan surveys accompany steep stock market declines. Although we’ve had two back to back negative days this does not even come close to being similar to previous market declines around such sentiment readings. The question then is, which part of the picture will change to return us to historical congruity? Will sentiment suddenly improve or will the market take a nose dive?

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