November 12, 2010

This morning, the University of Michigan released their widely watched Consumer Confidence survey results. You have been hearing about consumer confidence for years, but what does it really mean for you as an investor? Is there a causal relationship with markets? The economy?

Fret no longer. Here is your Cheat Sheet to Consumer Confidence :

The consumers power is often taken for granted. Moreover, we tend to underestimate the financial IQ of consumers by lumping them into an anonymous demographic and overblowing their irrational emotions regarding the future state of the economy.

However, if we can better understand the forces and indications of consumer confidence,  we can benefit from the next several months of consumption patterns.

Consumer Confidence Matters

You may have asked, How does the consumer – guided by superficial animal spirits – have any real power over large markets and the economy? Or, Can anything be learned from the majority’s beliefs about the markets? The answers are Yes.

Personal consumption accounts for more than 2/3 of our Gross Domestic Product (GDP). Therefore, when consumers change spending habits, they immediately move the economic needle. But before credit cards melt during spending sprees or collect dust during recessions, consumers must possess a certain level of confidence to either spend for not.

Measuring Consumer Confidence

How do we measure consumer confidence so we can get ahead of the investing curve? Three main sources collect highly respected data:

• The Washington Post-ABC News Consumer Comfort Index . Is a rolling average based on telephone interviews with 1,000 randomly selected adults over the previous four-week period. Interviewees are asked about the state of the nations economy, the state of their personal finances, and whether they are buying things at the current time.

• T he Conference Board Consumer Confidence Index . This survey is based on a representative sample of 5,000 U.S. households. Interviewees are asked about their short-term outlook, their current financial conditions, and their perceptions of the job market.

• The Thomson Reuters/University of Michigan Consumer Sentiment Index . At least 500 telephone interviews are conducted each month in the United States. Interviewees are asked 50 core questions such as how they felt financially six months ago, how they feel about their current conditions, and what they expect six months in the future.

Using Consumer Confidence Measurements

These indices are made public so investors, businesses, and banks can decide whether to invest. Further, the Federal Reserve considers this information when deciding whether to change interest rates.

In general, we can make two broad conclusions about consumer confidence data:

1. Decreasing confidence implies a future decrease in spending (i.e. economic recession).
2. Increasing confidence implies a future increase in spending (i.e. economic growth).

However, consumer confidence is known as a lagging indicator of future economic activity. This means findings are only as recent as the month they were published, and our most recent polls prove only what was popular a month ago. This delay in reporting the information leaves a gap in which consumers may change their perspectives.

Consumer confidence usually sinks to its lowest at the end of a recession, and peaks at the end of an expansion. Therefore, extreme measurements are used often by contrarian investors as a signal for an imminent reversal in sentiment.

Also, analysts like to breakout the expectations data as a forward-looking indicator. However, trusting consumer confidence is difficult because there is often a disconnect between investment markets, the economy, and the way consumers perceive things. Regardless, Consumer Confidence data is an important tool for savvy investors who combine the information with other observations in their framework.

How do you use Consumer Confidence data? Let us know in the comment section below

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