Consumer Credit and Stock Returns

Some investing experts cite consumer credit as a potentially important indicator of future stock market behavior, hypothesizing that an expansion (contraction) in credit indicates growing (shrinking) corporate sales, earnings and ultimately stock prices. Is there a reliable relationship between consumer credit and future stock market returns? The Federal Reserve collects and publishes U.S. consumer credit data on a monthly basis with a delay of about five weeks. Using monthly seasonally adjusted total U.S. consumer credit data for January 1943 through December 2011 and monthly Dow Jones Industrial Average (DJIA) closes for January 1943 through January 2012 (828-829 months), we find that:

The following chart depicts on logarithmic scales total U.S. consumer credit and DJIA over the entire sample period. Both series have generally risen as the U.S. economy grows (and inflates), but the stock market is more volatile than consumer credit. Visual inspection is not helpful in discovering any actionable relationship between the two series.

To dig deeper, we relate changes in the two series.

The following scatter plot relates next-month DJIA return to monthly change in consumer credit over the entire sample period. The Pearson correlation between the two series is -0.02 and the R-squared statistic 0.00, indicating that monthly variations in consumer credit explain nothing about next-month stock market movements.

To investigate potential non-linearity in the relationship we consider average next-month stock return by range of changes in consumer credit.

The next chart summarizes average next-month DJIA returns across quintiles of ranked monthly changes in consumer credit over the entire sample period (165 observations per quintile) and two equal subperiods (83 observations per quintile). There is perhaps an indication that extreme contractions in consumer credit indicate relatively strong next-month stock returns the next month, but the relationship between change in consumer credit one month and stock market return the next month appears largely random.

Standard deviations of returns within quintiles are generally higher for low than high quintiles.

Might changes in consumer credit lead changes in stock market returns by some interval greater than one month?

The next chart summarizes correlations for lead-lag relationships between monthly DJIA returns and monthly changes in consumer credit ranging from stocks lead consumer credit by 18 months (-18) to consumer credit leads stocks by 18 months (18). All correlations are small. There is perhaps some cumulative indication that stock market returns lead changes in consumer credit by many months in a positive relationship, with higher (lower) stock prices leading to more (less) consumer borrowing some months later. There is perhaps also weak cumulative indication that changes in consumer credit lead stock market returns in a negative relationship, with more (less) consumer borrowing leading to lower (higher) stock prices.

To investigate further, we relate annual changes.

The final two charts relate next-year DJIA return to annual changes in consumer credit (upper chart) and next-year change in consumer credit to annual DJIA return (lower chart) over the entire sample period (68 years).

The first chart confirms that annual change in consumer credit have a slightly negative relationship with next-year stock market return, explaining about 1% of the variation.

The second chart confirms that annual stock market return have a positive relationship with next-year consumer borrowing, explaining about 6% of next-year changes in consumer credit.

In summary, evidence from simple tests does not support a belief that consumer credit is a useful indicator of future stock market behavior. There is some support for a belief that bull (bear) stock markets predict future credit expansions (contractions) over many months.

Cautions regarding findings include:

• Analyses do not account for (or do not precisely account for) the five-week lag in Federal Reserve publication of consumer credit.
• This analysis does not rule out the possibility that surprises in consume credit expansion/contraction, relative to some measurable expectation, more usefully forecast stock market returns.

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