Sentimental Journey: Indicators Give Mixed Messages

Imagine the economy as a three-legged stool, supported by consumers, businesses and investors. Among each of these groups, sentiment about the future -- whether bullish or bearish -- can affect decisions that ultimately sway the course of the economy. Because sentiment drives spending, it can have a huge impact on the economy and the markets.

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There is a caveat, though, and that is that anything as emotionally volatile as opinion can be hard to gauge and may change considerably from month to month. Sentiment gets even murkier when the people being surveyed are asked to look many months into the future. And in a weird paradox, the optimism of one group sometimes depends on the pessimism of the others -- institutional investors, for example, are eager for the day when retail investors and consumers fold their cards and capitulate, signaling (finally) that the market has bottomed.

Despite their limitations, sentiment indicators still offer a way to figure out what's behind the nation's financial behavior. Below, we've tried to suss out the economic outlook among these three pillars of support by highlighting some key indicators and looking at what they collectively say about the economy.

So far, the signals are decidedly mixed: Consumers seem anxious about the long term, and investors, while calling themselves bullish, are acting somewhat bearish. Meanwhile, in a move that's likely to dampen confidence across the board and have more negative reverberations throughout the economy, businesses are putting a chill on spending. It remains to be seen whether or when all these groups will surrender and line up solidly in the bearish camp, but for now pockets of optimism persist.

Consumer Sentiment

Surveys on consumer confidence, considered leading indicators of spending, are always closely watched because consumer spending is so crucial to economic health, accounting for two-thirds of U.S. economic activity. The latest snapshot of sentiment from the Conference Board, released Feb. 27, was notable for its gloom. The consumer confidence index fell to 106.8 from 115.7 in January. Confidence in February declined for the fifth-straight month, hitting its lowest point since June 1996, when it stood at 100.1.

The survey was also significant for revealing the biggest divergence ever between how consumers perceive the economy now, and how they believe it will look six months from now. While expectations for the future are at a level seen prior to a recession, consumer sentiment about the present is cautious and consistent with an economy growing at a slow pace, according to Lynn Franco, director of the consumer research center at the Conference Board.

Which of those two findings says more about how people will behave with their wallets? Are we about to turn into tightwads, or will we keep spending at the usual feverish pace? According to one study that looked at 28 years of data, what consumers expect to happen in the economy down the road is generally a better predictor of spending than how they feel about the economy at the present.

But the implications of that study, conducted by economist Jason Bram and senior economist Sydney Ludvigson of the Federal Reserve Bank of New York, don't necessarily predict what will happen with consumer spending in any given period, especially in the short term. And it's worth noting that forward-looking sentiment is often more volatile than sentiment about the present, because consumers constantly adjust their expectations about the future to changes in the economy.

Still, Franco says the index is worth watching because of what she calls the "fear factor." "There can come a point where the prophecy becomes self-fulfilling, where the fear causes consumers to slow spending, and that could push an already sluggish economy into a recession," she says.

No less an authority than Fed chair Alan Greenspan has been keeping a close watch on consumer confidence numbers. In testimony before a Congressional committee earlier this week, he said he would continue to pay close attention to the surveys, especially after the steep drop off over the last few months. "But for now, at least," he added, "the weakness in sales of motor vehicles and homes has been modest, suggesting that consumers have retained enough confidence to make longer-term commitments." According to last week's release from the National Association of Home Builders, for example, housing demand remains strong on a historical basis, despite the fact that sales fell 11% in January.

Although consumers appear increasingly bearish about the future, another indicator of consumer sentiment -- personal spending -- hasn't shown much sign of slackening. In what has come to be a pattern, the rise in spending in January outpaced the rise in personal income. And the personal savings rate for January was negative, meaning that consumers continued to spend more than they earned. There hasn't been a monthly savings rate number that deep into the red since the Commerce Department began recording monthly numbers in 1959.

What gives? Well, it may be that consumers are buoyed by the force of habit and a still ultra-low unemployment rate of 4.2%, as of January. Or they may be comforted by the stock market wealth they've built over the years, notwithstanding last year's battering.

Of course, with layoffs accelerating, consumers may eventually decide to rein in their spending habits. "Obviously as consumers become more and more apprehensive, and job security becomes a greater issue, it's going to spill over into income expectations," says the Conference Board's Franco. Sustained worry about diminishing incomes would seem likely to put a crimp on spending. But that hasn't taken place just yet.

Investor Sentiment

Generally there's a correlation between consumer and investor sentiment: When investors are optimistic about the stock market, consumers tend to be optimistic about the economy, says Meir Statman, a behavioral finance professor at Santa Clara University. Judging from their still healthy spending patterns, American consumers don't seem incredibly worried yet, and investors seem not to have thrown in the towel, either.

The latest sentiment survey from the American Association of Individual Investors shows bullish sentiment to be on the upswing from last week, with 46% of investors counting themselves in the bull camp, 34% in the bear camp and 20% neutral. Compare those results to the same figures exactly one year ago, in the wildly buoyant period leading up to the spring tech crash. Back then, fewer investors were optimistic than now: 37% of investors professed themselves bullish, 23% bearish and 40% neutral. At this point, after countless earnings warnings and a sharp market pullback year-to-date, the capacity for investors to classify themselves as bulls is noteworthy.

Of course, signs of increasing optimism won't be welcomed in some quarters, because they suggest the market may not have reached a bottom yet. That's because, historically, investors tend to be bullish when the market's going up and bearish when it's going down. If anything, Statman says, bearishness precedes a rise in the stock market. So the lack of bearish sentiment at the moment may bode ill for the market.

However, it isn't easy to square investors' self-described bullishness with their recent behavior. In February, investors withdrew $13.4 billion more out of stock funds than they put into the funds, according to TrimTabs.com. As TSC's Ian McDonald reported, that's the first time stock funds have seen net redemptions since the neurotic month of August 1998, amid the emerging markets crisis and the near-collapse of Long Term Capital Management.

And in another sign of nerves, investors have increasingly been funneling their cash into money market funds. Cash in money market accounts has reached new highs in recent weeks, according to the Investment Company Institute. In the last week of February, money market accounts saw slight withdrawals by institutions, but retail investors kept on making contributions. That large amount of cash sitting on the sidelines has the potential to give the market a boost should investors decide to start moving it into stocks. For now, though, it seems to be an indicator of continuing wariness towards the market.

Corporate Sentiment

On the corporate side, sentiment is probably best reflected in spending. Here the outlook is pessimistic, as companies sharply curtail expenditures in response to slumping demand and back-ups in inventory. One closely-watched gauge of manufacturing health, the National Association of Purchasing Management's Purchasing Managers' Index, rose slightly in February, but remained within a range associated with recessions.

Another indicator of manufacturing activity, durable goods orders, came in well below economists' expectations in January. Orders of goods like large appliances, electrical equipment and automobiles dropped 6%, twice the forecast decline of 3%.

There seems little, then, that's equivocal from the corporate standpoint. In a domino effect, company after company has moved to cut costs and protect the bottom line, with only a few mavericks like Intel(INTC Quote) aiming to increase spending.

But there remain those few distracting bullish signs from the consumer and investor side. Is it possible that the existence of conflicting signals offers some hope, suggesting at least that the economy isn't all gloom and doom? Don't put too much stock in that idea, says Statman, pointing out that economic signposts never all point in the same way at the same time.

Even the nastiest markets have been characterized by confusion, he says. "It might look like everyone was gloomy in the bear market of '73-'74, but of course they were not. It might seem like stock prices just went down each and every day back then, but they did not. Almost half the days, probably, stocks went up, like today." Just like now, the economy then was full of mixed messages.