Americans are happy to spend their cash, but will the confidence last?

Americans are happy to spend their cash, but will the confidence last?
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On Friday, the University of Michigan reported that its Consumer Sentiment Index reached a 13-year high of 101.1 in October, up from 95.1 in September, an unexpected leap in confidence. Big gains were reported in both the index for economic conditions, which rose to 116.4 from 111.7, and expectations, which rose to 91.3 from 84.4.

At the same time, the American Association of Individual Investors reported that pessimism among individual investors about the direction of the stock market in the short term had decreased to its lowest level in a month. The most recent Investor Sentiment Survey also showed increases in both bullish and neutral sentiment. Bullish sentiment, or expectations that the stock market will rise over the next six months, rose 4.2 percentage points to 39.8 percent, which is above its historical average.

While people are optimistic, is this positive sentiment unfounded? As the stock market and consumer confidence are reaching new highs, many articles on preparing for the inevitable market correction, or even crash, are plentiful on popular financial websites.

It would seem that the record levels of consumer sentiment are somewhat justified, as there are many positive signs that the U.S. economy is healthy and that the future is bright. A greater percentage of Americans are employed than has been the case over the past 15 years. Unemployment is near all time lows, falling to 4.2 percent in September. This is the lowest jobless rate since February 2001.

The outlook for corporate America is extremely strong. Corporate earnings for the S&P 500 have grown by 6.1 percent, 15.5 percent and 10.8 percent, respectively, in the past three quarters. Earnings are expected to rise by another 4.0 percent this quarter. The early indications are that the vast majority of companies reporting earnings so far this quarter are exceeding analyst expectations.

Inflation is extremely low. In fact, the concern of many financial pundits is that inflation is too low and may result in the Federal Reserve delaying actions to increase interest rates and normalize monetary policy. Consumers like low interest rates and tend to buy more goods when rates are low. Finally, the specter of lower taxes looms on the horizon. While true tax reform is highly unlikely, tax cuts are a distinct possibility. After repeated failures to repeal ObamaCare, it would seem that tax cuts are an issue that could possibly unite Republicans.

Low unemployment, strong corporate earnings, low inflation, and potentially lower taxes are all rational reasons why consumer confidence is high. Many people, or at least economists, used to believe that individuals are rational and calculating when it comes to making financial decisions. That isn’t the case today, as the field of behavioral economics has become more and more popular. Just this month, University of Chicago Professor Richard Thaler received the Nobel Prize for his work in behavioral economics.

Current sentiment is being driven by a behavioral finance construct known as the wealth effect. In essence, as perception of one’s wealth increases, an accompanying increase in spending generally results. People have seen the stock market rising, believe they are wealthier, and are loosening their purse strings.

Most of us prefer to purchase goods when they have fallen in price. We see 50 percent off signs and are much more willing to part with our hard earned cash. Yet, most stock investors are more comfortable buying stocks after a price increase instead, fearing that they will miss out on even greater gains.

While consumers and investors have reasons to be optimistic, they would be wise to temper their enthusiasm and heed the words of Berkshire Hathaway’s Warren Buffett who famously said, “Be fearful when others are greedy and greedy when others are fearful.”

As a footnote on the recent Nobel Prize, when asked how he would spend the $1.1 million prize, the economist Thaler told reporters, “I will try to spend it as irrationally as possible.” Even the brightest minds realize humans aren’t rational. That is why trying to forecast the direction of the stock market is a fool’s errand.

Instead of being too spooked or too optimistic this October, it might be wiser to think about the direction of the stock market over the long term, which marches higher over time and always creates benefits for for those who are willing to wait.

Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed and Investment Banking for Dummies.