A Technically Bullish Market v.s. Downbeat Consumers

Last week, we noted that the stock market remains very bullish based primarily on technical considerations. Based on our optimistic assumptions ($672 Price Target and 21% CAGR), the benchmark SPY ETF is not overbought in the longer term, despite the elevated sentiment and overbought/oversold score. A technical formation called a “cup and handle” has just been completed, suggesting there is further upside to $600 by year end (+5% upside).

Such suggests that any near term weakness should be fairly well contained and can be bought by investors needing additional equity exposure in their portfolios. The last time we have identified a similar technical backdrop occured in December 2023, although in that particular case, the formation spanned 2 years instead of 2 months. As defined by Investopedia:

“The pattern was first described by William J. O’Neil in his 1988 classic book on technical analysis, How to Make Money in Stocks. A cup and handle price pattern on a security’s price chart is a technical indicator that resembles a cup with a handle, where the cup is in the shape of a ‘u’ and the handle has a slight downward drift. The cup and handle pattern is considered a bullish signal, with the right-hand side of the pattern typically experiencing lower trading volume. The pattern’s formation may be as short as seven weeks or as long as 65 weeks.”

Of course, the Fed’s decision to lower interest rates by 50bps last week is the main fundamental backdrop for the bulls. Over the last decade, investors have been taught a simple lesson, almost in a pavlovian way:  Any financial or recessionary event jeopardizing the markets would be met with rate cuts and accommodative policy. Whenever the Fed cuts rates, buying is in order.

Following that logic, markets surged on healthy volume, with all higher beta sectors making broad gains. This leads to an elevated Sentiment reading, stopping just short of “Extreme Greed”. The counterpoint here is that for the market to make fresh all-time-highs, optimism about the future is a requirement, so this predicament is less worrying than before.

However, there is a piece of data not quite aligning with the market’s bullishness: Consumer Confidence. The CB Consumer Confidence Index measures U.S. consumer optimism about current and future economic conditions, reflecting their likelihood to spend and influence economic growth.

Furthermore, as equity ownership in the US is nearing record highs, there is a growing link between consumer confidence and the stock market via the “wealth effect”, as Ben Bernanke pointed out in 2010:

“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

So far, it seems like the average consumer is relatively pessimistic compared to what the stock market is predicting. Consumer Confidence is now closer to the pandemic lows than the pre-pandemic highs:

The underlying reason for the downward shift is the change in the “Present Situation” index, which has taken a decisive turn lower. Expectations have largely remained in the same range as the last couple of years.

The erosion in “Present Situation” confidence is most likely directly linked to the complete drawing down of pandemic era excess savings. Research from the Federal Reserve Bank of San Francisco indicated that by March 2024, American households had fully spent their excess savings with estimates turning negative, suggesting not only that the savings buffer had been exhausted but that spending might have dipped into regular savings or other financial resources.

Combined with rising concerns about job losses, the hit to savings becomes particularly relevant as far as sentiment is concerned. Since 2022, respondents saying “Jobs are plentiful” have steadily decreased.

In a service based economy (like the United States, where services make up ~70% of GDP), the health and sentiment of the consumer is of paramount importance. An optimistic consumer is one more likely to spend, borrow, and invest, driving periods of economic growth. Conversely, when confidence is low, consumers tend to save more and spend less, which can slow down the economy.

Since the performance of the stock market is heavily impacted by GDP growth, we are paying attention to what the consumer is saying and prevailing spending trends. Currently, we are facing a dichotomy - a divergence between the implications of a rising and technically strong stock market, and a consumer who is not so excited about “everything else” except their portfolio returns. There have been 3 other times in recent history when the markets did well, while the consumer was becoming less confident:

1. The Dot-Com Bubble (1999–2000)

A notable instance of stock market exuberance disconnecting from consumer sentiment emerged during the dot-com bubble of the late 1990s. While stock prices surged, consumer confidence lagged as the economy began to weaken. By the early 2000s, signs of economic distress became evident in corporate earnings reports. The aftermath of the dot-com bubble resulted in the loss of trillions of dollars in market capitalization, which significantly impacted consumer confidence and contributed to a mild recession.

2. The Global Financial Crisis (2007–2009)

Before 2008, the stock market experienced substantial growth. However, consumer confidence began to decline as early as 2007. Worries over the housing market grew as mortgage defaults increased in the subprime sector. Despite these early indicators, the stock market maintained its bullish bias until the acknowledgment of slowing economic growth and recession prompted a market valuation adjustment. Consumer confidence fell dramatically alongside the market, and the U.S. economy slipped into the Great Recession, resulting in a significant bear market and extensive financial hardship.

3. COVID-19 Pandemic (2020)

The latest instance took place in early 2020. As the virus disseminated globally, consumer confidence experienced a significant decline due to escalating unemployment, extensive lockdowns, and uncertainty about the future. While consumer confidence reached multi-year lows in April 2020, it had been struggling even before the pandemic began.

What’s the takeaway from this? Although the stock market may exhibit optimism, the disparity between consumer sentiment and financial markets is not sustainable. Sooner or later, confidence will need to align with the market or vice versa. Historically, as demonstrated, it has been the latter, as markets face disappointment when they confront the reality of slowing earnings growth.

In backward looking EPS reports, we have not seen evidence of slowing earnings just yet:

A peculiarity of the current consumer psychology is a phenomenon called “Doom spending”.

"Doom spending" refers to the act of impulsive or excessive spending as a response to anxiety, stress, or feelings of uncertainty about the future. It often occurs during challenging times, such as economic downturns or personal crises, when people seek comfort or distraction through purchases, despite financial instability. Given all of the data presented above, it was an utter surprise to find so many respondents in the same CB survey say they are planning a foreign vacation soon.

Furthermore, the latest level of Initial Jobless Claims --a leading indicator -- (218K) and the trend from August and September point to a stronger than expected labor market.

Our Trading Strategy

“When all the experts and forecasts agree — something else is going to happen”, Bob Farrell

Bob Farrell’s investing idioms hold true in many cases and we’re big fans of his! It’s true that whenever everyone is on the same side of the same trade, no further gains are possible — that’s basically what Bob is implying in his saying.

At the moment, we argue that not everyone is as bullish as possible, despite elevated readings of sentiment. Conflicting data points exist, like we have outlined above. Is consumer “doom spending” enough to propel EPS growth next year and avoid a recession? Can the Fed push the stimulus pedal just enough to spur a more optimistic consumer?

We honestly have no idea (no one really does) and that’s not the point of risk management. We need to recognize the bullish technical underpinnings of the current market and the elevated equity exposure that our automated strategies are considering and simply “play the game” until something else happens. For now, SPY is poised to finish the year near resistance at $596 (R1), with support at recent highs ($561, M-Trend).

In our upcoming Portfolio Rebalancing, we will further refine the scope of our investments to account for the sectors, factors and individual stocks poised to outperform.

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!