Chart Shows Investor Sentiment Out of Touch with Reality

To some people in the mainstream media, last week’s advance estimate on U.S. gross domestic product (GDP) growth was seen as a positive surprise.

According to the U.S. Department of Commerce, the advance estimate on U.S. GDP growth for the third quarter of 2013 was an annual rate of 2.8%. In the second quarter, real GDP growth was 2.5%. (Source: U.S. Department of Commerce, November 7, 2013.)

Reading just the headline, it would be easy to assume that GDP growth was accelerating on a solid footing. However, had they looked just a bit deeper, they’d find that the truth is the GDP growth estimate that was reported was actually much worse than the headline number.

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The fundamental strength underpinning this increase in GDP growth was temporary, and it could lead to a much weaker fourth quarter. If investor sentiment were propelled higher due to this blip in GDP growth, it would be a mistake.

The big increase in GDP growth was due to a build-up of inventory, a reduction of imports, and an increase in spending by state and local governments.

What happened to consumer spending, which makes up three-quarters of our economy? Personal consumption increased by 1.5% in the third quarter versus an increase of 1.8% in the second quarter. People began to reduce their spending versus the first half of the year.

Inventory increased by $86.0 billion in the third quarter, versus a $56.6 billion increase in the second quarter and a $42.2 billion increase in the first quarter.

Just the increase in inventory alone added 0.83% to the GDP growth figure. If investor sentiment is increasing based on this figure, investors are missing the point.

Companies are building up inventory just as consumers are beginning to pull back on spending due to stagnant wages and a lack of cash to spend on discretionary items. Does this sound like a bullish scenario going forward? It certainly doesn’t to me. This is why I continue to believe that investor sentiment has gotten far too optimistic and bullish on the discretionary consumer sector.

The above chart combines the Consumer Discretionary Select Sector SPDR XLY exchange-traded fund (in red) that comprises discretionary stocks, and the University of Michigan Consumer Sentiment index (in black). The general idea behind this chart is to show how far investor sentiment in discretionary stocks has gotten ahead of actual consumer sentiment.

While consumer sentiment did increase during the first half of 2013, since that time, it has pulled back and erased most of the gains since the fall of 2011.

Investor sentiment, however, has continued pushing discretionary consumer stocks ever higher. Even during the peak of consumer sentiment earlier in 2013, we are still far below those levels during the middle of last decade. Investor sentiment appears to be ignoring this fact.

This divergence cannot continue forever. Either GDP growth picks up enough to drive jobs growth and incomes higher—which will lead to a rebound in consumer sentiment and eventually increased spending on discretionary items—or these stocks have to sell off to meet the weakness in the economy.

Looking at the current economic level, with GDP growth increasing primarily on higher inventory levels and no increase in consumer spending, I just don’t see how the elevated level of investor sentiment for consumer discretionary stocks makes any sense at this point.

With real GDP growth leaving the average American behind, I believe the level of investor sentiment has gotten far too optimistic for discretionary stocks, being far ahead of the underlying economic fundamentals. I would continue avoiding these sectors that are overly optimistic.

However, one sector that has become unloved by investor sentiment is mining stocks. As sectors move in and out of favor with the investing public, I’ve found that by buying sectors like mining stocks when others are selling them and investor sentiment is low, I’m able to accumulate companies at a low valuation.

Conversely, you don’t want to be the last investor standing by paying a huge premium in a sector that has become over-extended. Right now, with mining stocks at multiyear lows due to a decline in investor sentiment, I think they are offering an attractive value for the long term.

This article Chart Shows Investor Sentiment Out of Touch with Reality was originally published at Investment Contrarians