Investing Indicators: Consumer Sentiment

Economic indicators typically include quantifiable data such as the number of new construction permits or the number of houses constructed during a period of time. However, the financial confidence of consumers also plays a vital role in the economy's general health. A tracking index can help investors decide when to invest in consumer-staples retailers such as Wal-Mart (NYSE: WMT  ) and Family Dollar (NYSE: FDO  ) or higher-end sellers such as Tiffany & Co. (NYSE: TIF  ) or Macy's (NYSE: M  ) .    . 

The Thomas Reuters/University of Michigan consumer sentiment index measures how comfortable -- or confident -- consumers feel about spending money in the current economic climate. Results come from telephone interviews and the index would show a perfect score at 100.   

December's final consumer sentiment reading was 82.5 overall -- inline with the preliminary estimate but below the expected 83. December's figure was up nearly 10% from November's 75.1. The gain came from retail's strong promotional environment at the moment, economic confidence returning after the shutdown, and personal income gains mostly for those in the top third of earners.  

So what can an investor do with the consumer sentiment readings? 

Investment plays
As the indicator's name would suggest, the clearest path to benefiting from sentiment growth is to invest in consumer goods. Weak growth points toward investing in consumer staples and stores with lower-priced products, such as Wal-Mart and Family Dollar. Continued strengthening means investors can move further into discretionary retailers such as Macy's or Tiffany & Co.

US Consumer Sentiment Chart

US Consumer Sentiment data by YCharts

However, as the chart shows, share prices of these companies won't mirror the indicator in the same way that happens with some other indicators, such as housing starts and builder stocks. Wal-Mart moves most closely to the indicator because its customer base tends to have the least consumer confidence in general so economic changes hit particularly hard. When Wal-Mart customers lose confidence, as happened during the recession, Family Dollar stands to benefit.  

On the opposite end of the spectrum, Tiffany's customers tend to have more economic confidence than consumers in general so its share price is less connected to the indicator. Macy's exists on a sweet middle ground as it has a more diverse mix of customers that helps remove some of the volatility from consumer confidence.  

So the consumer confidence index is more of a hint about current economic conditions than a blinking red sign pointing at a particular stock. However, when confidence shows consistent improvements, the time could prove right to move some consumer stocks off the watchlist. 

Investors can also play the indicator more broadly with a consumer goods ETF. The Consumer Staples Select Sector SPDR Fund  (NYSEMKT: XLP  ) is highly liquid, which allows for easier trading, and contains a broad but easy-to-understand bucket of holdings. Food and staples retailers account for around a quarter of the ETF's holdings, with household products and beverages coming in close behind. The fund's affordable with a 0.18% expense ratio. 

Foolish final thoughts
Consumer sentiment continues to improve with the upper third of earners feeling the most confident. However, part of that confidence comes from a strong promotional environment that retailers can't sustain for the long run. So it's a good time to buy consumer goods stocks, but only while avoiding companies that rely too heavily on promotions. 

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