Behind the Scenes: How Consumer Sentiment Sparked a Hidden Stock Market Rally

The Consumer Sentiment survey from the University of Michigan presents further causes for concern regarding the state of U.S. stocks and the economy.

The latest University of Michigan (UMI) measure shows a significant upswing in consumer sentiment, a trend that often goes against normal predictions. The surge in the sentiment index from June to the initial July figures marks the greatest rise since December 2005. Over the past year, the sentiment measure has escalated by 21.1 percentage points, representing one of the most substantial 12-month leaps since the inception of this monthly survey in 1978.

Previously, increases as large as this one resulted in below-par performance, as evidenced in the accompanying chart. To be included in the top 5% of months with the largest increases over the last 12 months, there was a requirement of a minimum 17 percentage point increase. Therefore, the surge indicated by the preliminary reading in July fits comfortably within this category. The performance figures for the S&P 500 SPX, +0.71% represent the total return, adjusted for inflation.

Despite what you might think, a surge in consumer sentiment doesn’t always precede high stock market returns. Consumer sentiment is more often contemporaneous rather than predictive of market shifts. This was evident over the last year when an uplift in investor sentiment led to an increase in equity purchases, simultaneously pushing the market upward. Thus, the anticipated stock market surge due to a rise in consumer sentiment has already occurred.

The cause of the lowered returns following this mounting enthusiasm is due to our tendency to overreact. When we feel good, we tend to become excessively excited. When our optimism subsides, we often plummet into despair. These extreme reactions usually lead to a certain level of adjustment, as per the principles of contrarian analysis.

Think back to a year ago, the UMI sentiment index was drastically dropping during that period, with the greatest 12-month downfall happening from June 2021 to June 2022 since 1978. However, fast forward to the present, the S&P 500 has seen an overall return increase of 20%.

The current emotional climate is quite the reverse of what it used to be. Advocates for growth should pay attention.

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