Is Consumer Confidence a Double-Edged Sword?

To astute investors, consumer confidence is a double-edged sword. And, as Harry pointed out, it is often misunderstood.

For the average layperson, consumer confidence is interpreted in a simple way:

High consumer confidence is good.

Low consumer confidence is bad.

Investors, however, see it a bit differently:

Rising consumer confidence is good.

Extremely high consumer confidence is dangerous.

There’s a fundamental idea in contrary investing that says the consumer/layperson/retail investor is always “wrong” at market tops and bottoms. Specifically, they’re overconfident at market tops and overly pessimistic at market bottoms.

This is why Harry is concernrned, not impressed, with the very high levels of consumer confidence at the moment. It’s a sign that the market is potentially more hopeful than is justified. Eventually, reality will strike and investors’ hopes will be dashed.

That said, unjustified overconfidence can persist for a long time before the market punishes complacent investors. What I mean by that is, you can’t simply sell short the whole market just because consumers seem overly optimistic.
There’s a better way…

Spread trades give investors the opportunity to greatly reduce risk, while still participating in the market. Let’s look at two consumer-driven sectors: Consumer Discretionary (XLY) and Consumer Staples (XLP).

As the name suggests, the Consumer Discretionary sector comprises companies that sell “discretionary” products/services – meaning, consumers don’t need these products, they just want them. In tough economic times, and in bear markets, consumers cut back on spending in this category.

On the other hand, the Consumer Staples sector holds up better in tough conditions because consumers continue to spend money on staple products, like food.

Here’s a chart of the two sectors, with a ratio line comparing the two at the bottom of the chart.

See larger image

As you can see, the ratio line is currently at a high level, indicating the Consumer Discretionary sector has been doing better than Consumer Staples. This makes sense with the high level of consumer confidence Harry was talking about.

If excessively high consumer confidence is a warnrning signal of a potential downturnrn to follow, it stands to reason the current relationship between the discretionary and staples sectors will reverse. Meaning, Consumer Staples will begin to do much better than Consumer Discretionary.

One way to play this theory is to put on a spread trade. This involves buying one security and selling short a related security (equal dollar amounts invested in each). In this case, we’d buy the Consumer Staples sector (XLP) and sell short the Consumer Discretionary sector (XLY).

By taking offsetting positions, you’ll experience less volatile swings in your account balance if the market goes up or down. But if the market goes down, you should come out ahead as your short position in XLY should drop much faster (making a profit) than will your long position in XLP.

Think of it as an “insurance” trade protecting against a market drop.

Right now the S&P 500 is holding above 1,400. That’s a bullish sign so now isn’t the best time to put on this trade. If the market drops below 1,400 there’s reason to be cautious. Placing this trade is one way to get some protection when this happens.

If you haven’t done so already read the Survive & Prosper issue on “Consumer Spending or Consumer Confidence – Which is a Good Sign.”