The complicated relationship between consumer sentiment and stocks
Since Covid, the typically positive correlation between consumers’ mood and stock prices has collapsed, research finds.
Conventional wisdom has long held that the more optimistic consumers are, the better it is for the stock market. We decided to put that to the test.
What we found is a lot more complicated than some might think. That conventional wisdom held true for many years. But since Covid struck in 2020, the relationship has reversed: When consumer sentiment has been high, stock returns generally have been low, and vice versa. (In recent weeks, that relationship has reversed again, and we’ll see if that lasts.) One way to look at it is to say that where there once was a solid relationship, there no longer is.
To study this phenomenon, my research assistants (Aakriti Adhikari and Edmund Leigh) and I pulled a variety of asset-class returns going back to the 1980s and then matched that data with the University of Michigan consumer-sentiment index. The asset classes explored: U.S. growth stocks, U.S. value stocks, U.S. small-caps, U.S. large-caps, international stocks, as well as all manner of U.S. corporate and Treasury bonds and global sovereign and corporate bonds.
We began by examining how consumer-sentiment levels related to asset returns over the past 40 years. We defined periods of high consumer sentiment as when the Michigan consumer-confidence index was at the 75th percentile or higher. And we defined periods of low consumer sentiment as when the Michigan consumer confidence index was at the 25th percentile or lower.
Stocks and sentiment in sync
Over the full sample period, we saw results just as one would expect: When consumer sentiment is doing well, money flows into riskier assets and these assets outperform, and when consumer sentiment falls, money moves out of riskier assets and these assets underperform.
For instance, when consumer sentiment has been in the 75th percentile or higher, U.S. growth stocks have averaged a return of 1.39% a month.
Yet when consumer sentiment has been in the 25th percentile or lower, U.S. growth stocks have averaged a return of 1.06% a month.
Since 2020, however, we have seen a considerable shift in correlation: The riskiest assets do poorly when consumer sentiment is high and better when it is low. Indeed, while consumer sentiment has been low in the post-Covid era—the University of Michigan sentiment index is about 15% below pre-Covid levels—the S&P 500 is up nearly 90%.
When we look at U.S. large-caps, which are relatively less risky than smaller stocks, they delivered an average return of 1.79% a month when consumer sentiment was at the 25th percentile or lower.
And when consumer sentiment was at the 75th percentile or higher, these stocks delivered an average monthly return of negative 4.17% a month.
Lost confidence
So why have riskier assets not been moving in tandem with consumers’ confidence as had been the case for most of the past four decades?
Ultimately it’s a question that requires deeper exploration, but one possible explanation is that consumer spending largely hasn’t been the driving force in market returns since Covid struck. Instead, technological changes like the artificial-intelligence revolution have been driving recent market returns outside of any demand from consumers as investors pour money into companies like Nvidia and other tech titans.
Still, the results highlight that while consumer sentiment was historically something useful to track with respect to asset returns, it has become unreliable since 2020. And the fall from grace of consumer sentiment means one less useful measure that investors have in guiding their expectations on returns and portfolio-allocation decisions.
Derek Horstmeyer is a professor of finance at Costello College of Business, George Mason University, in Fairfax, Va.
topics
