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Come Rain or Come Shine
By Jim Wiandt

Related ETFs: DON

Illustration By Robin Jareux

There are some indexes that exert an outsized influence on the emotionally-charged psyche of investors. By and large, they're the direct measures of the market's actual performance: the Dow, the Nasdaq, the S&P 500. When the Dow first rose above 10,000, for instance, euphoria set in, as a famous article proclaimed "Dow 35,000." When the index fell back below 10,000, there was panic in the streets.

But there are a few indexes that measure more intangible subjects - things like productivity and growth - that act as market drivers in and of themselves, in the same way that the intangible 

veiled pronouncement of Soothsayer Greenspan move the markets. Foremost among these is the University of Michigan Index of Consumer Sentiment. Even if you get the feeling things are looking up, if the magic number of the Consumer Sentiment Index is unexpectedly low, you know that the market is going down. Longer-term, the correlations to the market are more volatile. However, it's no surprise that generally, when the market (and the economy) are looking up, consumer sentiment is high, and as sentiment drops, so does the market.


 




Despite its ability to rally the bulls or rouse the bulls, however, few people know anything about how this important index is created, and what it really means for the economy and the markets. In this article, you'll actually see how the index works, what its predictive (or reactionary) nature to the macro-U.S. economy is, and an array of nifty facts, figures and quirks about the index that you can pull out in bar room bets with geeky would-be market mavens.

An Overview

The University of Michigan Index of Consumer Sentiment is actually just one part of a broader series of economic indicators put out each month as the Univeristy of Michigan Surveys of Consumers. Founded in 1946 by Professor George Katona, and overseen today by Richard T. Curtin at the University of Michigan , the Survey of Consumers is used to create three separate indexes: 1) the famous and ubiquitous Index of Consumer Sentiment, 2) the Index of Current Econonic Conditions and 3) the Index of Consumer Expectations. Taken together (and often separately), the indexes are widely recognized as accurate leading indicators of the direction of the U.S. economy. In fact, the third index - the Index of Consumer Expectations - is actually included in the Leading Indicator Composite Index published by the U.S. Department of Commerce (an index that is worthy of an article of its own).

But for the markets, the most important of the three remains the Index of Consumer Sentiment.And for an economic index that has such wide influence, the methodology of the Index of Consumer Sentiment is remarkably simple. The number rests in the hands of just 500 randomly surveyed continental Americans (residents of Alaska , Hawaii and outlying possessions of the U.S. need not apply). Essentially the survey consists of 50 different questions covering an array of issues related to the economy. The results of the survey are the distilled into three different numbers representing the three core indexes. The survey goes far beyond just the three indexes, however. The three indexes, in fact, only look at 5 questions. The rest of the data in the survey can be (and is) sliced and diced, analyzed by demographics, etc.

The basic methodology behind the actual indexes, however, is extremely simple.

How it Works

For every ten traders that have bought or sold stock on a Consumer Sentiment announcement, I doubt there's probably one investor who actually knows how the index works. We aim to change all that - in the index world anyway - with a five-minute skull session covering the index basics.

First of all, lets take a look at the Index of Consumer Sentiment, which is represented by the number you see that pops up on CNBC around the seventh day of each month. As I mentioned, only five of the 50 survey questions are used in calculating the three indexes. Here they are:

•  We are interested in how people are getting along financially these days. Would you say that you (and your family living there) are better off or worse off financially than you were a year ago?

•  Now looking ahead - do you think that a year from now you (and your family living there) will be better off financially or worse off, or just about the same as now?

•  Now turning to business conditions in the country as a whole - do you think that during the next twelve months we'll have good times financially or bad times, or what?

•  Looking ahead, which would you say is more likely - that in the country as a whole we'll have continuous good times during the next five years or so, or that we will have periods of widespread unemployment or depression or what?

•  About the big things people buy for their homes - such as furniture, a refrigerator, stove, television and things like that. Generally speaking, do you think now is a good or bad time for people to buy major household items?

With the results of those questions in hand, the University of Michigan people take all the favorable replies minus all of the unfavorable replies for each question and add 100 to that number, rounding each score to the nearest whole number.

These five numbers are then added together and then divided by 6.7558 (think index divisor - an explanation of which will follow shortly).

The finishing touch is the bonus addition of two points, to compensate for creeping modern nihilism (actually, according to the University of Michigan , it is a constant added to correct for sample design changes from the 1950's). And that's it. Here's how it looks in a formula:

ICS = X 1 + X 2 + X 3 + X 4 + X 5 + 2.0

6.7558

The other two indexes work in exactly the same way, but only use two and three of the five selected questions, respectively. The Index of Current Economic Conditions (ICC) looks at responses to the two questions relating to (you guessed it) current economic conditions, while the Index of Consumer Expectations (ICE) looks at the three questions relating to perceptions of the future. The only differences in the calculations are the divisors.

ICC = X 1 + X 5 + 2.0

2.6424

ICE = X 2 + X 3 + X 4 + 2.0

4.1134

To see which questions are used for each index, note that the subscript in the above formulas corresponds to the specific number of the five questions that were listed out previously.

Implications of the Index Divisor

The part of the calculation of the indexes that strikes me as most interesting (and which I've never heard remarked upon in press coverage of the ICS) is the divisor. The divisors of these indexes follow the same concept as the divisors for equity indexes. Their purpose is to give the index a nice round number at a base date in history. As a recent example from the equity index world, the New York Stock Exchange recently reset its divisor to give their trademark NYSE Composite index a base value of 5,000 - as of December 31, 2002 , as opposed to the old base value of 50 from year-end 1965. In the case of the Index of Consumer Sentiment, a base of 100 was set in February of 1966.

In short, the base of 100 was set at a time when Americans were feeling chipper, according to the survey - so an index number of 100, or even 90, actually reflects a great deal of optimism. Here is the part which surprised me during my investigation of the index: for the index to be at 100, 66% of the respondents must feel positive about the economy, and 34% negative. Back to the equation:

66% favorable - 34% unfavorable = 32 +100 = 132X5 = 660 divided by 6.7558 = 97.69 + 2 = About 100.

If the results are 50/50, you get 500 divided by 6.7558 - 74+2 = 76.

Upon reflection, it feels like the Index scores line up about right with how grades have worked in recent years. George W. Bush's "gentleman's C" of years gone by would be a disaster to today's students , and ditto for the Index: uUntil early 2003, when it dipped to 77.6 in February and March, the index had not seen the 70s since 1990-1993, when we'd also dipped into a recession. Of course, in George W's formative years, a constant stream of 70s was the norm: we hit the 70s every year from 1969 through 1983, except for 1972 (thanks Dick) and 1976-1978 (200 Years! Disco!). After years of wild optimism, by early 2000, we'd blasted off to a record 112. You know the rest.

For a full listing of the monthly data, sample survey questions, etc., please visit the extended version of this article on http://www.indexuniverse.com/, in the Journal of Indexes section. We've also posted all of the links on .

The current index has generally, but not always, outpaced the expectations index. So we generally feel better about how we're doing now than about how things are looking going forward, right? Well, maybe, maybe not. In the case of core survey questions number 1 and 2, the results are nearly always that people expect to do even better in the coming year than they have in the previous year.

•  Would you say that you are better off or worse off financially than you were a year ago?

•  Do you think that a year from now you will be better off financially or worse off, or just about the same as now?

But the buying question (#5) helps skew the results toward current, as most people almost always think now is a good time to buy. Perusing the last three full years of the survey, for example, you'll find average scores on Question #5 in the 140s and 150s.

Breakdown by Survey Questions and Current and Expectations Index

Recent Survey Results for Each Question and The Three Indexes
  Personal finance Business Cononditions Buying Conditions
(5)		 Current Index
(1,5)		 Expected Index
(2,3,4)		 Consumer
Sentiment Index
(1,2,3,4,5)
DATE OF SURVEY  Current 
(1)		  Expected 
(2)		  12 months 
(3)		  5 years 
(4)
January 2001 123 126 106 115 157 107.7 86.4 94.8
February 2001 122 129 93 102 152 105.8 80.8 90.6
March 2001 119 131 97 109 148 103.4 83.9 91.5
April 2001 110 134 92 104 143 98.0 82.2 88.4
May 2001 112 129 99 115 152 102.2 85.4 92.0
June 2001 117 126 114 109 146 101.6 86.9 92.6
July 2001 114 133 115 107 141 98.6 88.4 92.4
August 2001 118 127 102 113 144 101.2 85.2 91.5
September 2001 108 128 71 95 136 94.6 73.5 86.8
October 2001 107 128 77 98 136 940 75.5 82.7
November 2001 107 134 76 97 140 95.3 76.6 83.9
December 2001 108 138 86 106 148 99.0 82.3 88.8
January 2002 105 141 111 115 143 953 913 93.0
February 2002 106 137 106 107 143 96.2 87.2 90.7
March 2002 113 135 120 117 147 100.4 92.7 95.7
April 2002 113 134 115 109 144 99.2 89.1 93.0
May 2002 110 136 121 116 159 103.5 92.7 96.9
June 2002 103 138 113 102 155 99.5 87.9 92.4
July 2002 106 133 91 100 151 99.3 81.0 88.1
August 2002 110 131 95 97 146 98.5 80.6 87.6
September 2002 103 130 100 91 145 95.8 79.9 86.1
October 2002 99 132 74 87 140 924 73.1 80.6
November 2002   97 129 93 92 143 93.1 78.5 84.2
December 2002     104 135 91 97 144 96.0 80.8 86.7
January 2003 107 126 80 86 145 97.2 72.8 82.4
February 2003 102 127 66 86 145 95.4 69.9 79.9
March 2003 96 128 63 87 136 90.0 69.6 77.6
April 2003 111 131 87 99 139 96.4 79.3 86.0
May 2003 97 138 120 110 144 93.2 91.4 92.1
June 2003 102 136 111 100 143 94.7 86.4 89.3
July 2003 110 135 106 95 155 102.1 83.7 90.9
August 2003 109 124 111 97 150 99.7 82.5 89.3
September 2003 106 133 97 94 148 98.4 80.8 87.7
October 2003 111 127 108 98 148 99.9 83.0 89.6
November 2003 107 128 122 104 158 102.5 88.1 93.7
December 2003 105 122 128 112 146 97.0 89.8 92.6


Correlation to Various Indicators in the Macro Economy

There are 45 survey questions that are not used to calculate the index. A number of these have been proven to be remarkably predictive of various factors in the economy, including employment, interest rates, GDP growth and inflation rate. The Consumer Sentiment survey results tend to be predictive of changes in these economic factors, in much the same way that the stock market tends to be predictive of the state of the economy…that is, the expectations tend to lead actual growth or decline in these rates by about six months. Following are charts covering expected and actual GDP and employment rate changes. 

 



Standard Margins of Error

Based on the equal probability sampling method that is employed by the survey, it is possible to arrive at standard errors for all three index numbers at a confidence level of 95%. Essentially, this means that, for example, when you look at monthly data for the Index of Consumer Sentiment, there is a 95% probability that the survey results are within 3.29 points, plus or minus, of the results you would arrive at if you were able to survey every adult in the continental U.S. This , remember, with just 500 individuals surveyed. Perhaps January of 2003 was the blip in data that fell inside that 5%, as the month came in at 103.8amidst a two-year sea of 80's and 90s.

University of Michigan Surveys of Consumer Sentiment



What this methodology, is, essentially, is a word of caution to survey watchers to take small changes in the index with a grain of salt. The vast majority of historical month-to-month changes in the Survey of Consumer Sentiment have, in fact, fallen within these margins of error.

Minimum Period to Period Change Required for Statistical Significance at 95% Confidence Intervals for the Surveys of Consumer Sentiment


Random Notes of Interest

In perusing the survey data, I came across a few interesting facts:

  • Wealthy people are much more optimistic than poor people. Families with household income of over $50,000 generally have Consumer Sentiment scores 10-15 points higher than those of families with less than $50,000 in household income. I suppose it's not too surprising that your outlook is brighter on economic issues if you're doing better economically.
  • I made an earthshaking discovery as I sifted through the tea leaves of the Consumer Sentiment index data. I'm tucking it into this late part of the article, so that only the very dedicated and industrious among you can reap the rewards of this knowledge. Yes, there is a January effect and an October effect in the index. First of all, let me explain to you how this happened. I'm combing through all the monthly and quarterly data and I notice the aforementioned January blip from this year in the data. I carelessly glance through the data. And like a bolt of electricity standing my hairs on end, I come to the realization, "Could it be?!" My mind at this point is afire, as I delve deeper and deeper into the data. And there it is, in black and white for all (or at least the very dedicated or mindlessly number-fixated among us) to see: In 21 of the past 26 Januaries (yes, Melinda, that's a cool 80.8%), January sentiment has outpaced December sentiment. At this point, driven like a madman on the verge of nirvana, I begin looking at Octobers. As we all know, Octobers don't seem to be great market months. And there it is - another diamond amidst a sand dune of data - 19 of 26 Octobers (73%!!!) have underperformed the preceding September's sentiment.
  • In addition to the wealth effect, there are a couple more demographic statistics that we can throw into the mix to wrap things up. 1) People in the West of the U.S. are the most optimistic/contented among us, followed by Midwesterners, Southerners and Easterners - although there is a lot of overlap from month to month, and, to be honest, I'm just sort of eyeballing the data. 2) Young people (18-34) are the most optimistic/contented, followed by middle-agers (35-54) and then spiraling wildly to despondent 55+ year-olds. With age, unlike region, there is absolutely no doubt at all about the numbers.

Conclusion

The University of Michigan Surveys of Consumer Sentiment sheds some interesting light on consumer sentiment and its effect on spending and hiring patterns, and therefore the very course of the economy. For this reason, the benchmark Index of Consumer Sentiment is highly watched and well-regarded in the worlds of finance and academia. Indeed, there are few instances in which any index, let alone one that has had its genesis in an institution of higher learning, has such a profound effect on both the economy and how people view Consumer Sentiment and its effect on the economy.

 

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