The Baby-Talk Indicator

Story Highlights:

• Consumer confidence ticked up in April, a positive development but not necessarily a prediction of what stock prices will do next.
• Consumer spending, which makes up the largest portion of GDP, is tied more closely to disposable income than consumer confidence.
• Consumer confidence is usually highest around stock market peaks and lowest around market bottoms. It can be wise to sell when people are euphoric and buy when they're overly pessimistic.
• The 2008 bear market was unusual because the previous bull market ended in pessimism, not euphoria.

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Endless entertainment can be had watching new parents interact with their infant children. Most babies start mouthing vowel sounds after just a few months, and their parents fawn over each captivatingly cute auditory attempt. Mama says "ma-ma," baby says "a-a," and the room erupts in cheers. Baby babble is a cute developmental milestone, but otherwise doesn't mean much. Consumer confidence is like baby talk; it largely mimics recent stock prices but the numbers lack meaning looking forward.

Tuesday, the New York-based Conference Board reported US consumer confidence rose sharply in April. Of the households surveyed, 25.3% believed business conditions will worsen over the next six months, compared to 37.8% in March. Conversely, 15.6% expected improvement, up from 9.6% last month. While not a resounding surge of euphoria, these numbers could indicate improving sentiment.

Economists frequently use consumer confidence to predict future consumer spending, which comprises roughly 70% of GDP. But consumer confidence reflects what's already happened, not what will happen in the future. Disposable income is a much better indicator of consumer spending, and therefore economic output, than consumer sentiment. Why? Studies show consumers tend to spend their paychecks. A bigger paycheck translates fairly well into more spending. Consumer confidence reports, like all surveys, are biased by the way people ask and answer questions. They're also backward-looking and not necessarily predictive of future behavior. Who wants to say they feel good about spending their wad while people are losing their jobs?

Consumer confidence roughly follows the stock market. During the 1990s, stock prices generally rose ahead of consumer confidence, peaking near the pinnacle of the Tech bubble in 2000. Confidence fell throughout the bear market until early 2003, reaching a low point near the market bottom. Similarly, this month's uptick in sentiment largely reflects stock market performance in March—the best month for global stocks since April 2003 (this April is shaping up nicely too). Bear markets often begin when euphoria peaks and end when pessimism spikes. This last bull market ended oddly with pervasive pessimism rather than euphoria. Though consumer confidence rose into 2007, it never reached extreme levels and was far below its 2000 peak.

Just like a baby cooing her first adorable babble, we can watch rising consumer confidence with a smile, but should not split hairs deciphering its meaning. Rising stocks already told us sentiment has shifted.