Which reverses first – Stock prices or low consumer confidence?

By Filipe R. Costa

I would like to congratulate the Federal Reserve for its aggressive intervention in financial markets, which not only put a floor under the crisis, but also effectively pushed asset prices higher creating wealth across America. The 2007/09 Financial Crisis halved stock prices, dented household income, destroyed jobs and led to negative GDP growth for several quarters.

Now, four years after the end of the crisis (or its peak at least), the US economy is apparently back on track, with its stock market moving towards all-time highs. But can the market move further higher?

I always like to take a look at the Schiller P/E ratio to check how current valuations compare with the past. A high P/E ratio signals an alarm bell and is a sign that the risk of holding stocks is higher, as they may be overvalued against historical standards. Of course, stocks can still continue rising, but the risk/return becomes more and more unfavourable.

The current reading of the Schiller P/E is 23.94, a value that is way below the tech bubble highs, but is near the pre-crisis 2007 levels. In fact, the Schiller P/E was near 28 just before the latest crisis started. The Schiller index value dropped to 13 by March 2009, as the wider stock market lost 50% of its value. With the S&P500 now up 150% since that bottom, the P/E ratio has risen substantially once more.

Although the Schiller P/E index is not at the highest levels, witnessed before the bursting of bubbles, it remains to be seen if investors can tolerate current prices. The alternative is we might be near a top.  

The following chart shows the progress of the S&P500 and the Michigan Consumer Sentiment over the last few years:

The yellow line represents the S&P500 and there are three tops circled. The first of these occurred at the end of the tech bubble, the second at the end of subprime and the third is market today.

If you look at the green line you will see that even though it seems to react to market rises, consumer sentiment has been trending down for the long-term. Consumer sentiment was near 110 before the tech bubble, near 90 before the subprime crisis and is near 80 now.

The Fed has justified its policies (of targeting interest rates to encourage house and stock prices higher) as stimulating a wealth effect and sustaining consumer confidence. Their hope has been that when people feel wealthier and more confident they will spend more. The problem with this is the data suggests that this plan has not been working. The consumer clearly isn’t at all happy!

So, congratulations Mr Bernanke! You’ve done a great job in driving asset prices higher. The pity is that this policy has only really helped those who own assets. Consumer confidence is down substantially, after a decade of Fed intervention. At the same time, the Schiller P/E is heading towards its highs. Given that a healthy economy requires healthy spending, clearly this disconnect cannot last forever. Either people will need to start spending again or stock prices must come down.

As for you, dear reader, just take your pick which outcome you feel is most likely.