Opinion | Why Does Consumer Sentiment Follow the Stock Market?

A funny thing happened on the way to the 2024 election. Well, actually, a lot of funny things happened. (Ron DeSantis!) But I’m talking about the economy. As I wrote in my latest column, there seems to have been a sudden upswing in consumer sentiment, which is finally starting to catch up with the reality that inflation has plunged while unemployment has remained low.

And I do mean sudden. Here’s a chart from the Michigan survey, the most widely cited measure of consumer sentiment:

OK, this is just one survey, and some of what we’re seeing may be statistical noise; other surveys also show improved perceptions of the economy, but not as sudden a break. Still, it’s interesting to ask what might have led to a jump in how Americans are feeling about the economy. And one obvious candidate is a rising stock market.

There is, in fact, good reason to believe that stock prices affect perceptions of the economy. What’s less clear is why. So let me take a sentimental view of the stock market — that is, look at its relationship to consumer sentiment. (No, I don’t have warm and fuzzy feelings about the Dow.)

The evidence that the stock market affects consumer sentiment rests in part on average statistical relationships; see, for example, this 1999 Federal Reserve analysis. It also rests on a few striking cases. Here’s my favorite example, consumer sentiment during 1987-88:

Why did consumer sentiment plunge for a few months in the fall of 1987, then recover? Nothing much was happening to the real economy — no big changes in unemployment, inflation or economic growth. What did happen was Black Monday on Oct. 19, 1987, when the Dow suddenly plunged 22.6 percent for no obvious reason.

Should consumers care when the stock market gyrates? Arguably, most of them shouldn’t.

True, while only a minority of Americans own stock directly, a majority have some exposure to the market once you take into account indirect holdings, especially retirement plans. But even once you include these indirect investments, most people’s stake in the market is small. In 2022, according to the Federal Reserve, the average American household directly or indirectly owned almost $500,000 worth of stocks. But these holdings were concentrated in the highest-income 10 percent of the population; the median household owned only $52,000.

So most Americans shouldn’t care much about what happens to stock prices, at least in terms of the direct effect on their finances.

Still, doesn’t the stock market predict the future of the economy as a whole? No. In 1966, the great economist Paul Samuelson quipped that the stock market had predicted nine of the last five recessions. Subsequent experience has borne out his skepticism. The 1987 crash didn’t presage a recession; neither did the bear market of 1998:

Why are stock markets so bad at predicting recessions? I can think of at least three reasons.

First, nobody is any good at predicting recessions, a fact that we’ve seen spectacularly demonstrated by the failure of all those 2022 recession predictions to come true. Stock traders sometimes have special insights into (or inside information about) particular companies, but when it comes to the economy as a whole, they have the same problem as all forecasters: It’s really hard to call turning points.

Second, stock prices are arguably driven even more by human psychology — by hope, fear and greed — than most other asset prices. So stocks often soar or plunge for no real reason.

Finally, it’s not even clear whether the prospect of a recession should lead to lower stock prices. Yes, a recession leads to lower profits, which, other things equal, should hurt stocks. But the Fed normally responds to recessions by cutting interest rates, which, other things being equal, should help stocks. Which effect will dominate? It’s not obvious.

Incidentally, this last point suggests that the bond market, which largely reflects expectations about future Fed policy, should be a better guide to the economy’s future. Also, bonds aren’t as sexy as stocks, so bond trading is probably more rational. Historically, an inverted yield curve — short-term interest rates above long-term rates — has been a useful predictor of recession. But not this time, at least not so far.

Anyway, the point is that ordinary Americans shouldn’t be judging the economy by looking at the stock market. Yet many of them clearly do. Why?

One answer is that while the stock market may be a poor indicator of the state of the economy, it’s highly visible. The latest move in stocks is constantly showing up on your TV or your smartphone, in a way other economic data isn’t. So it’s somewhat natural for people to judge the economy by the numbers they see all the time.

Another answer is that news coverage of the economy may be strongly affected by stock prices, even if it shouldn’t be. Stock movements are, after all, an easy hook on which to hang reporting. And dare I say it, news business executives on average surely have a much bigger stake in the stock market than the median American.

Sure enough, the San Francisco Fed’s index of news sentiment — which tracks the tone of news coverage rather than the moods of consumers — turned sharply higher when the current stock rally began:

So what should we make of the surge in consumer sentiment? On one hand, it makes a lot of sense given the reality of an economy with low unemployment and inflation. On the other hand, the timing may have been driven by a financial indicator most Americans really should be ignoring.

Oh, well.

Jordan Weissmann has been thinking along similar lines.

When Covid struck, Donald Trump sent supporters … a signed chart showing stock gains on his watch.

Stock prices offered no warning about the 2008 crisis.

“Sentiment is now just 7 percent shy of the historical average.”

He’s your guy
When stocks are high
But beware when they start to descend
It’s then that those louses
Go back to their spouses
Diamonds are a girl’s best friend

Source link

Related Articles

Leave a Reply

Your email address will not be published. Required fields are marked *

Back to top button

Get our latest downloads and information first. Complete the form below to subscribe to our weekly newsletter.

    Input this code: captcha