By Barry Ritholtz - November 16th, 2010, 7:30AM
“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?”>
-Dave Rosenberg, chief economist and strategist at Gluskin, Sheff
It is taken for granted that a rising stock market stimulates the animal spirits, sending consumers off shopping.
The basic premise of the wealth effect is well known: As the value of stock portfolios rise during bull markets, investors enjoy a feeling of euphoria. This psychological state makes them feel more comfortable — about their wealth, about debt, and most of all, about spending and indulgences. The net result, goes the argument, is that consumers spend more, stimulate the economy, thus leading to more jobs and tax revenues. A virtuous cycle is created.
The rule of thumb has been that for every one dollar increase in a household’s net equity wealth, spending increased 2-4 cents. For residential RE, the increase is even greater: Consumer spending increases 9-15 cents (depending upon the study you use) for every dollar of capital gain.
The problem is, the theory is its mostly nonsense.
I make this statement for two reasons: 1) the distribution of equities in the United States; and b) the classic causation/correlation issue.
Let’s start with equity ownership. The vast majority of Americans have a rather modest sum of cash tied up in equities. 401ks, IRAs, investment accounts — these are primarily the province of the well off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1%: They own about 38% of the stocks (by value) in the US. The next 19% owns almost 53%. That leaves the remaining 80% of American families with less than 10% stake in the stock market (See Federal Reserve’s Z.1 Flow of Funds report for the most recent info).
How is THAT going to cause a wealth effect? Especially when you consider the median family’s stock portfolio is worth well under $50k. These are the millions of families who are the principle consumers of cars, food, clothing, electronics, energy, health care, etc. To them, a rising stock market is nearly meaningless.
The biggest investment for the typical American household remains their home, with a median value of ~$200k. Put 20% down, and you see a 10 to 1 leverage. The impact of Real Estate on any wealth effect is much greater than the stock market. Unfortunately, homes remain somewhat overvalued — 10-15% by our measures — and are in a downtrend. They are not contributing to improvements in consumer spending in any meaningful way.
Our second factor is quite simple: The causation/correlation problem. In the 1990s, the Fed under Alan Greenspan focused in the past wealth effect of stock market gains. But I suggest they would have been better off looking at the myriad factors impacting consumer’s psyches: Plentiful jobs, wage increases, economic expansion, labor mobility, modest inflation, and bountiful credit availability. These are sufficient to explain the behavior of consumers. Its not a secular bull market in stocks that causes the consumer spending — its all the other contemporaneous elements that are the prime drivers.
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Regardless of your views of QE2 — if the Fed is doing it create a wealth effect, they are wasting their time and money.
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See also:
Housing Wealth and
Consumer Spending
January 2007
http://www.cbo.gov/ftpdocs/77xx/doc7719/01-05-Housing.pdf
Wealth, Income, and Power
G. William Domhoff
September 2005 (updated September 2010)
http://sociology.ucsc.edu/whorulesamerica/power/wealth.html
Housing Wealth Effects: Housing’s Impact on Wealth Accumulation,
Wealth Distribution and Consumer Spending
Eric Belsky and Joel Prakken
December 2004
www.jchs.harvard.edu/publications/finance/w04-13.pdf
Consumption and the Wealth Effect: The United States and the United Kingdom
Remarks by Governor Edward M. Gramlich
Before the International Bond Congress, London, U.K.
February 20, 2002
http://www.federalreserve.gov/boarddocs/speeches/2002/20020220/default.htm
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