Turn in Consumer Sentiment Could Signal Major Rally

By James Kostohryz  MAY 27, 2011 3:25 PM

A positive turn in the economic data could lead to a very substantial shift in bullish sentiment and produce a swift rally in equities.


In Why the US Economy Is in a Tricky Spot, I argued that the apparent slowing of economic momentum in the April data (that is reported in May) was related to a series of exogenous shocks (MENA (Middle East and North Africa) social and political unrest, Europe sovereign debt woes, Japan disasters) to sentiment in the March-April period that produced delays in purchasing decisions by businesses and consumers at that time. I also argued that the decline in sentiment would prove to be transitory and that sentiment data would probably rebound quickly in the May-July period, leading a concomitant rebound in the economic activity data reported for the corresponding period during June-August.

Today’s University of Michigan Consumer Sentiment report provides clear support for my contention.

Tracking the Trend in Sentiment and Its Impact

Readers should recall that in March, the University of Michigan Consumer Sentiment Index declined precipitously to a reading of 67.5, from a level of 77.5 reported in February. This dramatic slump in sentiment coincided with the barrage of bad news coming out of MENA countries and Europe. The continuation of these problems, and the addition of the various disasters in Japan, meant that sentiment barely rebounded to 69.8 in April. In May, these various exogenous issues have been relegated to the back pages, and consumer sentiment has rebounded strongly to a reading of 74.3. This progression in the data is consistent with my hypothesis.

The most important data in the University of Michigan report relates to the Consumer Expectations Index. This index component most closely tracks actual consumer spending, and for that reason, is a component of the Leading Index of Economic Indicators (or LEI).

The Expectations Index collapsed in March to 57.9 from a reading of 71.6 in February. The expectations index recovered slightly to 61.6 in April. However, as consumers gained perspective on the news, and the media attention focused the various external shocks has declined, the expectations index has risen very rapidly to 69.5 in May. This represents a very major improvement in the outlooks of consumers.

Interestingly, the one-year inflation outlook of consumers also declined substantially to 4.1% from 4.6% the month earlier.

In other words, the consumer sentiment data, and the expectations component in particular, is showing that the impact of external events on consumer sentiment is proving to be transitory. The data also tends to demonstrate that consumers in aggregate expect the effects of these external events on their personal economic situations to be transitory.

Provided that there are no further major exogenous shocks, it has been my contention that the sentiment shocks to business and consumer sentiment in the March-April period caused by various external events would prove transitory, and that sentiment would rebound in the May-July period. I have predicted that this improvement in sentiment will lead to a corresponding improvement in the economic data reported in the June-August time-frame.

My hypothesis regarding the trend in sentiment is being proven correct by the evolution of the consumer sentiment data reported by the University of Michigan. Now, we must wait for the May-July economic activity data reported between June and August.

Impact on the Stock Market

If I am right about the impact of the positive turn in sentiment on economic activity, a significant equity market rally may be in store.

Equity market sentiment is currently at extremely bearish levels due to fears about a slowing economy. Indeed, according to AAII, bullish sentiment is at 25.6% -- an incredibly sharp drop, since as recently at February readings were above 50%. The current level of bullishness is the lowest since August of 2010 and is one of the lowest levels registered since January of 2009. In this context, a positive turn in the economic data could lead to a very substantial shift in bullish sentiment and produce a swift rally in equities.

I reiterate my target of 1,450 on the S&P 500 by mid 2011. I will consider my prediction to be accurate if the target is reached by August. If readers want to know what would cause me to change my mind, they can read The End of QE2: Does It Matter? and Why the US Economy Is in a Tricky Spot.

In terms of stock and sector allocation, during the aforementioned rally that I expect to manifest in the next few weeks, I believe hard hit cyclical sectors should do well. However, I want to alert readers that I will use strength to reduce equity holdings overall and particularly in economically sensitive stocks and ETFs such as (IEZ) and (XLY) as well as economically sensitive regional holdings such as ILF.

After the recovery rally just mentioned, I expect a garden-variety 10%-20% correction associated with a turn in the global interest rate cycle some time in the third quarter.

At that point, a nice long-term buying opportunity may emerge and my sector holdings will probably change significantly from what they have been. I will write about this in coming weeks. One particular sector I will be highlighting will be financials, which can be played through stocks such as Bank of America (BAC) and ETFs such as (XLF). Large cap tech stocks such as Apple (AAPL), Intel (INTC), and Google (GOOG) also look quite attractive.

I would warn readers, however, that timing can prove critical and navigating the next few months could be tricky. I expect a rally, a correction and then another leg up to new all-time highs during 2012.

For now, I am focused on the potential short-term rally based on the turn in economic sentiment data and the concomitant turn in the economic data. Currently low investor sentiment provides a good backdrop for this type of rally scenario.
No positions in stocks mentioned.

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