Insight Line—April 21, 2008

The two most closely tracked consumer confidence surveys—from the University of Michigan and the Conference Board—may reveal the mood of Americans when they are surveyed, but these surveys rarely predict how much consumers will actually spend when they hit the malls. However, an updated analysis by Federal Reserve researchers suggests at least one of these reports, the Michigan Survey of Consumer Attitudes, offers more than an assessment of consumer sentiment. Indeed, this survey might actually offer a perspective on how much risk investors are willing to tolerate in their investment portfolios.

Federal Reserve researchers Gene Amromin and Steven A. Sharpe recently revisited their April 2005 analysis on the connections between consumer sentiment and investor attitudes about the economy, financial markets and portfolio construction. Their now three-year old finding remains firm. "In sum we find that when investors have a more favorable assessment of short- or medium-term macroeconomic conditions, they tend to expect higher returns." Additionally, "We find that the expectation of more favorable economic conditions has a strong negative effect on expected stock market risk."¹

This conclusion likely comes as little surprise to investors acquainted with the more widely known theories of behavioral finance. (Behavioral finance studies how human emotions influence market prices, returns and asset allocation decisions.) Yet, I believe Amromin and Sharpe set their research apart from the behavioral school by stating their view that investors seem to place a greater importance on the interaction between the economic outlook and market returns than on the interaction between market returns and the perceived level of investment risk in the market. Their research argues that the more optimistic survey respondents are about the future economic assessment, the more as investors they are likely to forgo diversification of risk in favor of more concentrated investment portfolios. Perhaps more importantly, in light of the growing prospect of an economic contraction in 2008, Amromin and Sharpe contend that lower equity valuations during recessionary times result from “undue pessimism on the part of investors about the economy, rather than high risk aversion."² While such conclusions do not appear radical at first glance, they actually represent a notable departure from the majority of prior works on consumer attitude surveys and market returns. You see, until now, the unchallenged consensus maintained that perceptions of market risk trump perceptions of economic risk.

Many years ago, one of Wall Street’s greatest minds, John Burr Williams, quipped that in order to be a good investment analyst, one needs to be an expert economist. Perhaps he wouldn’t mind if Amromin and Sharpe updated this idea slightly: In order to be a good investment analyst, one must also be an expert on investor perceptions about the economy.

So, while consumer confidence surveys remain less than helpful in predicting future economic activity, they may at least offer interesting guidance on how much risk investors may be willing to tolerate.

¹ Amromin, Gene and Steven A. Sharpe, "Expectations of Risk and Return Among Household Investors: Are Their Sharpe Ratios Countercyclical?" Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., January 2008.

² Amromin, Gene and Steven A. Sharpe, "From the Horse's Mouth: Gauging Conditional Expected Stock Returns from Investor Sentiment Surveys," Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., April 2005.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 4/18/08)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

As suggested in last month's Factors update the current rate economic activity does not auger well for rising employment. March 2008's 410m increase in the nation's labor force, when combined with a loss of 24m jobs moved the unemployment rate to 5.1 percent, its highest total since September 2005. Payroll measures of employment followed suit as the private sector continued to shed jobs in construction and manufacturing. As such, the appropriate circle remains Down.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up^*

Down

If there is a bright spot in the nation's 2007 economic picture, it is that personal income grew at a faster rate than the economy at large and the trend appears in tack so far in 2008. Total personal income, recorded a record level of $11.99 trillion at month's end February 2008. With that being said, the year-over-year inflation adjusted growth rates of disposable personal income are only slightly above year ago levels, thereby confirming a pressured consumer. Nevertheless, for now I suggest Up remains the appropriate circle on the table, but with an asterisk.

Retail Sales
^{(Source: Department of Commerce/Census)}

Up

Down^*

March's 2008’s retail sales advanced a seasonally adjusted .2 percent. The seasonally adjusted monthly total of $381 billion does not tell the whole story. You see the unadjusted data portrays an awaking economy from the depths of winter. One month does not a trend make; therefore, I suggest the continued appropriate circle on the chart remains Down—but with an asterisk.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The news on the new orders for manufactured goods in February 2008, at face value, is somewhat disconcerting. After all total new orders declined for a second month in row. Then again, the strength in unfilled orders, inventories and shipment levels, all remaining above those recorded in the fourth quarter of last year lends credence to last month's call to move the circle to up. While the overall picture in the nation’s manufacturing sector suggests little more than inventory and sales replacement rather than business expansion, export growth is keeping the manufacturing sector hard at work. Therefore, the appropriate circle is Up.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures, as reported in the February Personal Consumption Expenditure Index (ex-food and energy), sat at 2.0 percent year-over-year or at the upper end of the FOMC's preferred range. However, in that 2 voting members on the FOMC dissented at the March 18, 2008 citing rising inflationary pressures, this heightened awareness suggests moving the circle to High to reflect this vocal minority having established a voice at the discussion table. Please move the circle to High, irrespective of the fact that on a longterm basis the overall core rate remains at historically low levels. Please circle High.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

With a slowing economy and rebate checks in the pipeline, March's federal fiscal year-to-date shortfall of $311 billion dollar shortfall is a harbinger of things to come. The fiscal 2008 deficit may well top $425 billion or approximately 3 percent of the nation’s GDP. The appropriate circle on the chart, reflecting economic stimulus, is $In.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC reduced the overnight lending rate to 2.25 percent on March 18, 2008. The committee next meets on April 29-30 and it is widely expected to reduce the federal funds rate to 2 percent. In the interim the Federal Reserve Bank of New York, at the direction of the Federal Reserve Board, continues monitoring the daily developments in the shortterm lending markets. Please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield, reflecting recent Fed moves, now measures a positive 257 basis points. When viewed historically and in light of past economic contractions, the current shape argues that if a recession is underway more than likely it will be short-lived. Please Circle Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

The nation’s fourth quarter annualized GDP growth, after all revisions remained .6 percent. The year-over-year growth was 2.5 percent. As of this publication date, subsequently released data has yet to produce statistically irrefutable evidence of the economy recording negative growth in the first quarter of 2008. Nevertheless, in that the focus of this publication is to provide forward-looking analysis, there is ample support for forecasting below trend growth (3 percent) for the foreseeable future. Therefore, please circle Below.