Consumer Sentiment Plunged In August:  Is Heavy Consumer Pessimism Actually Good For Stocks?

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The week got off to a rough start on Monday when Standard & Poor's did the unthinkable.  The ratings agency wiped out the US government's once-invincible AAA credit rating, lowering it to AA+.  It was the first downgrade of US government debt in history.

And it threw the market's into a tizzy...

The Dow plunged 634 points on Monday as investors decided to shoot first and ask questions later.  Then on Tuesday, investors mounted a massive snap-back rally sending the Dow up by 429 points.  But the gains wouldn't hold up on Wednesday as the Dow plummeted 519 points.

While the stock market gyrated, other markets reacted to the debt downgrade by moving to extremes.  The yield on the ten-year Treasury note dropped to the lowest level ever recorded.  And gold surged to a new record high, topping $1,800 per ounce for the first time.

But by the end of the week, investors were looking for reasons to do some bargain hunting.

On Thursday, they got exactly what they were looking for.  New claims for unemployment stunned investors by coming in much lower than anyone expected.  And investors responded by driving the Dow an impressive 423 points higher.

That good news was followed by probably the most shocking economic data yet.

Retail sales rose more than analysts were expecting in July.  According to the US Census Bureau, retail sales jumped 0.5% from June's levels and increased by 8.5% year over year.

It may not look like much of an upside surprise, but it was the biggest retail sales increase in four months.

And investors used the news as an excuse to buy up badly beaten down stocks.  They sent the market up 125 points to close out the week on a positive note.

No doubt about it, the market's wild swings had many investors reaching for their favorite antacid last week.

But the most interesting part of the week wasn't the market's nasty bout of schizophrenia.  Nope, it was the market's reaction to a gloomy Thomson Reuters / University of Michigan Consumer Sentiment Survey.

The widely watched measure of consumer confidence plunged in August to the lowest level seen since May of 1980.  Many were expecting the indicator to drop modestly from 63.7 in July to 62 in August.

But it came in at an astonishingly low 54.9.

Major drops in consumer confidence are usually seen as a very bearish sign for the markets.  Remember, about 70% of US economic activity is driven by consumer spending.  And when consumers are fearful about the economy, they tend to keep wallets safely in their pockets.

However, August's steep drop might mean something different for the markets this time around.

Take a look at the following chart...


The chart shows the quarterly performance of the Michigan Consumer Sentiment Index from 1961 through January of 2011.  Now this chart doesn't show the August 2011 drop.  But August's reading of 54.9 is clearly going to produce a line down to a level between the historic lows of 2009 and 1980.

In other words, consumer confidence is currently at an extreme low.

What does this mean for investors?

It's actually a very bullish signal.

You see, whenever consumer confidence has fallen to this level, the market has mounted huge rallies.  In 1980, the S&P 500 turned on a dime and put up gains of 36%.  And after consumer confidence plunged in March 2009, the blue-chip index bottomed and then soared 105% over the next two years.

You can't argue with data like these.

Yes, consumers are clearly pessimistic.  But the data suggest this is about as bad as consumer confidence is likely to get.  What's more, the last two times consumers were this downbeat, savvy investors who bought stocks raked in huge profits.

Take this history lesson to heart.

If you've got some cash in your portfolio, it's a great time to put some of it to work.  A large number of high-quality stocks are now trading at bargain basement prices.  Start building positions now to participate in the coming rally off the consumer confidence multi-year lows. 

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