Thursday, August 10, 2006

Consumer Confidence and Stock Returns

Every week it seems some news agency is reporting consumer confidence numbers. For instance from ABC News:
" Consumer confidence is showing strain. Faced with the highest gas prices since Hurricane Katrina, soft job growth, and a cooling economy, it has slipped to its lowest level in seven weeks.

The ABC News/Washington Post Consumer Comfort Index stands at -12 on its scale of +100 to -100 this week, inching out of the -9 to -11 range at which it has hovered since late June."

The traditional interpretation is that consumers will not spend as much if they lack confidence. Thus the economy will slow down. But that said, there is still some debate as to whether the numbers really mean much.

Lemmon and Portniaguina
(L&P) join a long list of researchers who have tried to determine exactly how this sentiment measure matters. Specifically L&P examine whether confidence numbers can be used to further explain stock returns.

Why so many looks at the same thing? One reason is because the results are often contradictory. For instance some researchers (Lee, Shleifer, and Thaler 1991) find that the closed end fund discount can be described by investor sentiment, whereas others do not (Doukas and Milonas 2002).

What sets the L&P paper apar is that the authors break down confidence into (my terms) justified confidence and unjustified confidence. The unjustified confidence is interpreted as investor sentiment. (how cool is that?!)

How is this done? In the authors' words:
"First, we regress consumer confidence on a set of macroeconomic variables. Although the regression has a high R2 (around 0.6 – 0.8 depending on the specific confidence index), a substantial portion of confidence remains unexplained. We treat the residual from this regression as our measure of excessive sentiment (optimism or pessimism) unwarranted by fundamentals."
And now a theoretical time-out:
  • The majority of financial researchers and professionals hold that small traders are more prone to bouts of excessive optimism (and pessism) than are institutional traders.
  • Research has shown that individual traders impact small stocks more than large stocks (in large part due to liquidity differences).
Putting these two things together leads to the prediction that returns on small stocks should be more susecptible to sentiment swings. Namely, that if over optimism exists, small stocks will be over priced relative to large stocks.

Empirical findings:

Lemmon and Portniaguina find that their "excessive sentiment"measure can be used to describe stock returns.
"Consistent with the view that investor sentiment affects stock prices, we find that the pricing errors of small stocks exhibit larger time variation than those of large stocks and are higher following quarters of low sentiment. Thus we report evidence that investors appear to overvalue small stocks relative to large stocks during periods when consumer confidence is high, and vice versa"
Which is a really cool finding!

Want another cool finding? Try this one on for size:
"in the post-1977 period [where individual share ownership has increased], the sentiment measure based on consumner confidence exhibits strong ability to forecast the size premium"

Want still more? OK. The paper gives us even more:
"We find that, after controlling for time variation in beta, quarters of high investor optimism are followed by lower returns on dividend non-paying stocks, stocks with low earnings growth, stocks with low sales growth, and stocks with low institutional ownership. The results based on institutional ownership provide some additional evidence that is consistent with the idea that
individual investor sentiment is an important determinant of mispricing in stocks where arbitrage may be more limited"

Which deserves a WOW. A definite I^3 paper! (Important, Interesting, and Insightful!)

BTW I am currently ristening to Confidence by Rosebeth Kanter. So I might be hyper- sensitive to the idea that confidence matters....or maybe it goes back to middle school when after a particularly bad basketball game my mom made me a wall hanging with the CW Longenecker poem "If you think you are beaten you are" on it.

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