Why a lack of confidence is good

The December reading of the Conference Board's measure of consumer confidence was weaker than expected (52.5 vs. 56.3). Is that cause for concern? Hardly. As this long-term chart of the series shows, monthly volatility in the index is the norm, and the latest wiggle can hardly be seen. The only message to be found in this series is that consumers are still very un-confident. This is hardly surprising, since confidence almost always lags what is going on in the real economy. For example, it took about 3 years for consumers to begin feeling better about the economy following the recession of 1990-91. Plus, consumers don't usually get depressed until recessions are well underway.

The fact that consumer confidence remains low is a good reason for investors to be optimistic, because it means there is a lot of room for improvement. The rally in equity and corporate bond prices that began almost two years ago has been driven fundamentally by the discovery that the future was not turning out as bad as everyone had thought. In early 2009, markets were priced to the expectation of a very deep depression and years of deflation. Instead, we find the economy recovering and inflation low but not negative. Positive shocks such as this (the reality turns out better than the expectation) are what drive risky asset prices higher.

By the time everyone recovers their confidence in the future, prices will be a lot higher than they are today. You can't wait for the news to turn good before betting on higher prices. The current low level of consumer confidence is also a reason to doubt the warnings being issued by a number of pundits that the stock market is over-bought and frothy.

Investors—those with real skin in the game—are usually better at discerning the state of things. This chart of option-adjusted spreads on corporate debt is a good measure of how confident investors are about the credit-worthiness of corporate borrowers, and about the future of the economy. Spreads have come way down from their highs, as investors have realized that the world was not coming to an end, but spreads are still quite a bit above where they would be if the world were back to "normal" and confidence in the future were high. I think this jibes well with the consumer confidence numbers, with both confirming that there is still a good deal of caution and fear out there. We're a long ways from seeing speculative froth or another asset price bubble.