The Economy April 9, 2008, 6:33PM EST

The Consumer Spending Mirage

Stocks riding high on illusions of consumers continuing to spend may be in for a nasty surprise

by Michael Mandel

If you are an investor, this is the moment in the business cycle when fortunes can be won or lost. The U.S. economy is in recession, for the fourth time in the past quarter century. Will the stock market soon take off with a whoosh, as it did during the downturns of 1981-82 and 1990-91? Or will stocks continue to slump, like they did during the 2001 recession and beyond?

Forecasting the stock market is a fool's game—but there are grounds to believe there's another drop in the market yet to come. The reason: a broad decline in consumer spending, which so far has been masked by a quirk in the government's statistics. Combine that with a rapidly unraveling job market, high energy prices, and the continuing credit crunch, and you have the recipe for a drop in consumer stocks. A big decline there could take the rest of the market down with it.

Right now it's looking like the recession started in November, 2007. That's when private-sector employment peaked, according to the latest job report from the Bureau of Labor Statistics. Since then, the private sector has shed 300,000 jobs, with the cuts concentrated in construction, manufacturing, retail trade, and temp services.

Consumer Spending's Nice Ride

Despite those job losses, government statistics show that consumer spending, although slowing, is at an all-time high when adjusted for inflation. In fact, if you go by these numbers, it looks like Americans have boosted their purchases at a 1.4% annual rate since last summer, a respectable pace considering the chaos in the financial markets and the massive overhang of consumer debt they have piled up since 2000.

The apparent ability of the U.S. consumer to keep spending helps justify the remarkable rise in many top consumer stocks over the past few months, despite the housing bust. Increases in share prices since the end of August, 2007, include Wal-Mart (WMT), up 24%; Colgate-Palmolive (CL), up 19%; Avon (AVP), up 15%; Coca-Cola (KO) and McDonald's (MCD), both up 13%, and Procter & Gamble (PG), up 7%. Meanwhile the S&P 500-stock index (MHP) as a whole has lost 8%.

In one sense the strength of these particular companies isn't a surprise. They have all ridden the two-decade-long consumer spending boom, giving investors average annual gains ranging from 14% to 17% since 1988, including dividends. By comparison, the S&P 500 has returned an average of 11% per year over the same period.

Personal Consumption: Quirky Stats

But a closer look at the numbers shows that the consumer spending boom may already have come to an end, without investors noticing. The problem is this: What the government calls "personal consumption" is actually a grab bag of items, some of which don't really fit the usual notion of consumer spending. For example, the nation's current annual personal consumption of $10 trillion includes about $1.8 trillion in outlays by Medicare, Medicaid, and private health insurance providers. This is real money, but consumers don't control or even see most of it, since it usually goes right to the health-care provider.

The government's count of personal consumption also includes "imputed" categories, that is, entries that don't involve any money changing hands. Two of the biggest examples: $1.1 trillion for "rent" that homeowners theoretically pay to themselves to live in their own homes, and $240 billion for "services furnished without payment by financial intermediaries"—in other words, the value of services like no-fee checking accounts.

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