A Better Predictor than the Fed

The Fed’s theory on what motivates consumers to spend money presupposes our willingness to take on debt. Cheaper debt increases demand for loans, which in turnrn spurs consumer spending.

But what happens when consumers are no longer willing to take on debt? The whole theory simply falls apart.

Debt, pure and simple, is an obligation. And amidst tough economic times, many consumers today view debt as the proverbial “ball and chain.”

So think of it as a conversation, like this…

Fed: “How much will you pay to wear this ball and chain?”

Consumer: “Nothing.”

Fed: “I’ll give it to you for FREE!”

Consumer: “Don’t want it.”

For the set of consumers who are absolutely unwilling to take on additional debt – even if it’s free – there’s another model that may explain consumer spending better. In general terms it goes like this:

“If I have it, I spent it… if I don’t, I won’t.”

Tracking the degree of excess, discretionary income consumers have might just be a better way to predict economy-wide spending patternrns.

One way of judging excess discretionary wealth is with the Vice Index that Andrew Zatlin of SouthBay Research compiled.

He tracks how much money people spend on gambling and escorts. And here’s how well the Vice Index tracks the Personal Consumption Expenditures (PCE) data published by the Bureau of Economic Analysis.

See larger image

Pretty remarkable, right!

86% of the data in the Bureau’s PCE report can be predicted based on data from the Vice Index. What’s more, and of particular interest to investors – who can’t profit from delayed data – the Vice Index provides a four-month lead to changes in PCE.

That gives investors more than a full quarter to make adjustments to their portfolios, based on the level of consumer spending we can expect four months into the future. That’s immensely valuable.

Right now, the Vice Index is hovering around the zero line. But if the downward trend continues over the next few months, it could provide an early warnrning sign that consumers are running low on excess discretionary income.

I’ll give you an update on this index around the end of the year.