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Consumer Sentiment and the Stock Market...

Stocks may be in the beginning stages of a protracted decline brought about by the shifting tide of investor optimism. Surprising Wall Street on Friday was a steep decline in the University of Michigan's consumer sentiment index, falling to 87.5 from 96.8. The index peaked earlier this year concurrent with the top of the major stock indices.

There is a natural order to all things human. As such, the persistent bullishness that pervades every aspect of the stock and bond markets will soon come to pass. Since the market is really just an expression of investor optimism we can find clues to forecast stock market trends by charting consumer sentiment. Therefore we present to you our analysis of the long-term trend in the University of Michigan's sentiment index.

In the chart below we have graphed the UoM sentiment index going back to 1978. The 27-year study of consumer sentiment is enlightening in one key respect: Each major downturn has been milder than the last representing a bull market in enthusiasm about US prospects. The basing process in the stock market in late 2002 and early 2003 saw the UoM survey fall to a 10-year low of 79. Yet remarkably, sentiment ricocheted off the rising trendline support from the 1980 nadir of 51.7 through the 1990 low of 63.9.

The second thing that stands out is that the 80/90 levels mark key support/resistance and correlate well with the health of the economy. When the survey held above 90 the economy has been in expansion; below 80 in recession. The move back below 90 indicates that the economy is slowing. Yet a break below 80 this time could be more severe as it would represent a reversal of the 27-year trend in rising optimism. This would most assuredly lead to a dramatic decline in the stock market, a recession and possibly an escalation of military conflict.

Psychologically, the Dow's break of 10,000 last week following the disappointing payrolls report may be the catalyst to get things rolling to the downside. Mind you we aren't congenitally bearish. We just focus on inflection points and this market has shown extreme optimism while ignoring the deteriorating fundamentals.

Our core position since this bear market began was that deflationary cleansing is required in order to make room for new borrowing and the next boom. It is therefore impossible to "jumpstart" an economy a la Keynes until the debt is cleared away. That is why he said run deficits in bad times and pay them down in good. Corporations have done this but the nation as a whole financed a mini-boom with unprecedented debt accumulation. On the surface that looks good but must be matched by rising payrolls and the income they generate to pay back the borrowing. As I see it, this hasn't happened and the credit card bill is due in the mail.

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