As noted above, the University of Michigan Consumer Sentiment index received much attention last week.
The index is a monthly survey of at least 500 US households, who are asked about their current financial situation, economic expectations, and attitudes toward purchasing major household items.
The consensus estimate for February was a reading of 63, which would have been a little lower than the January reading of 64.7. When the actual reading came in at 57.9, markets were negatively surprised.
The lower-than-expected reading was part of the issue, but the other part is that the reading was below 60, which is considered severe pessimism, and is often seen during recessions. Readings over 100 are incredibly high (and rare), and anything over 70 reflects degrees of optimism.
The index dates back to the late 1970s, but I wanted to show a range around the index using three years of history, so my chart started in 1980.
I’ve also highlighted recessions, which are the gray vertical bars. In this time period, we’ve had five recessions, some longer than others.
What’s interesting to me, though, is that sentiment has been really bad since the pandemic. It took a long time, but the surveys showed that people were finally back to an optimistic state after the 2008 Global Financial Crisis (GFC) when the pandemic came along.
The index got to all-time lows in 2022, when inflation was surging, and stocks and bonds were both down. There was some recovery from that, but now, the index is off sharply again – about what it was in the 2008 GFC, which is a little surprising.
Ryan Craft showed a chart in his monthly chartbook that showed that investor sentiment can be contra-indicator, meaning when sentiment is bad, the returns that follow can be good (and vice versa).
I took his analysis a little further and grouped the Michigan Sentiment Index into three categories – below 70 (pessimism), 70-90 (moderate optimism), and over 90 (high optimism).
Then I calculated the one-year return for the S&P 500 from the Michigan readings and compared the results.
The chart below confirms what Ryan said (not surprisingly!).
When readings were below 70, the average 12-month return was 15.8 percent. When readings are between 70 and 90, the average subsequent one-year return is 12.0 percent, and when the readings are over 90, the returns are 13.3 percent.
Importantly, though, that doesn’t mean you should expect a 15.8 percent return from here just because the reading is low right now! The averages double-count periods because it looks at Jan-to-Jan, then Feb-to-Feb, etc. That’s why all three levels are above the 11.5 percent return for the whole period from start to finish.
The chart also shows that the risks are higher when the sentiment readings are this bad – almost 50 percent higher than when readings are below 70.
Another way to say that subsequent returns are volatile when the readings are low is to look at the range of returns. The worst subsequent return when readings were below 70 was -43.3 percent.
It wasn’t good when readings were between 70 and 90, at -38.6 percent. That’s better than -43.3 percent, but not by much. The worst return in the over 90 category is -26.6 percent. Again, it’s better, but hardly great.
The upside is intriguing because it’s best when the readings are low, up 61.0 percent. When the readings are between 70 and 90, the best subsequent year was 56.3—not quite as high, but still great. And when the reading was above 90, the best year following was 52.1 percent.
Here’s how I read it: we should expect a lot of volatility in the coming year. Talk about a bold prediction! Could we look back a year from now and think it was a great buying opportunity? Perhaps so. Could we see it was an “obvious” time to get out? Perhaps so.
In other words, it’s unpredictable, but Ryan concluded that the data suggests that risk and return are related, and I wholeheartedly agree. As I said last week, our asset allocation policy decisions capture all this statistically, even though we never know the story in advance.
One client and reader emailed me last week to say, ‘Keep the faith,’ to which I say: Amen!
