Wealth Effect The 'Wealth Effect' refers to the propensity of people to spend more if they have more assets. The premise is that when the value of equities rises so does our wealth and disposable income, thus we feel more comfortable about spending. The wealth effect has helped power the US economy over 1999 and part of 2000, but what happens to the economy if the market tanks? The Federal Reserve has reported that for every $1 billion in increase in the value of equities, Americans will spend an additional $40 million a year. The wealth effect has become a growing concern because more and more people are investing; furthermore the Federal Reserve has very little direct control over stock prices.
The numbers are staggering. Since the end of 1995, household stock holdings have doubled to more than $12 trillion dollars. And, for the first time, equities are the most valuable asset of the typical American household, not the home. When it comes to spending money, consumers take all their financial resources into consideration, from their income to their home. When an asset surges in value for a sustained period of time, such as the stock market in the 1990 s, people feel flush and are willing to spend some additional money, perhaps by buying a fancy car or by taking a more expensive vacation. A good number of Wall Street analysts blame the wealth effect for today's negative savings rate.
Declining stock prices affect firms in several ways. First, lower stock prices, especially induced by profit warnings, increase shareholder pressure on managers to cut costs by laying off workers and scaling back investment. Second, the recent correction has put many stock options underwater, and it is unclear to what extent workers will bargain for more cash in place of options and how this might affect payroll costs and inflation. Third, the factors dragging down stock prices typically spur investors to demand higher risk premiums, which boosts the cost of financing business investment. This takes the form of increased spreads of corporate bond and commercial paper interest rates relative to Treasury yields and lower prices for any new stock that any firm dares to offer.
Aside from raising the going price of new finance, the increased uncertainty associated with lower stock prices can spook investors so much, that the availability of finance is reduced. Since the fall, this has been manifested in tighter standards for bank loans, a drying up of lower grade corporate bond issuance, increased difficulty in using stock swaps to finance mergers, a dearth of IPOs, and a sharp slowing of venture capital investment. One source of uncertainty about the stock wealth effect is that we lack enough experience to pinpoint how much the decline of the Nasdaq will impact small business formation by affecting the venture capital market. Venture capitalists live for the day when companies in which they have invested can issue stock on the Nasdaq. At that point, the liquidity and marketability of their investments rise, allowing them to cash in their winning investments.
However, when the Nasdaq tanks-the red line-IPOs and start-ups typically slow any new venture capital investments-the blue line-dry up because venture firms see lower expected returns. Along with the Nasdaq, overall venture capital investing has fallen off from the rapid pace of the late 1990 s, particularly for high tech ventures, shown by the green line (1). Other venture capital investment, reflected by the gap between the blue and green lines, also trended with the Nasdaq. Nevertheless, because most of this investment is in business and consumer services, particularly in e-business and e-consumer service firms, the drop in other venture capital investment largely stems from the tech-wreck and the dot com bust. How Lower Stock Prices Affect Households Now let's turn to how lower stock prices affect household spending through two main channels.
One is that lower stock prices are associated with greater uncertainty and lower confidence, particularly because layoffs typically increase during such periods. Another channel is through lowering household wealth. Indeed, most estimates of stock wealth effects imply that for every $100, 000 decline in stock wealth, consumption falls by roughly 3 to 5 thousand dollars over the long run (2). However, there is much controversy over the conventional view of how stock wealth affects consumer spending. Criticisms of the stock wealth effect fall into at least four categories. One is that the savings rate has not really fallen and thus, the long bull market had not pushed savings down and the recent correction will not slow consumer spending.
Another is that any observed stock market effect merely picks up expectations or confidence about the future and so there is no independent wealth effect. A third criticism is that stock wealth is too highly concentrated among the super-wealthy for it to affect consumption. Finally, some economists are concerned that estimates of stock wealth effects are to imprecise to be useful. Some analysts question whether higher stock wealth has really lowered the savings rate, as measured by after-tax income minus consumer spending, because of measurement problems. They correctly point out that the income series used equals labor plus interest and dividend income minus taxes on those income sources and taxes on capital gains, even though realized capital gains are not included in the income measure. For this reason, the official savings rate is downwardly distorted by realized capital gains, especially in bull markets, such as that of the late 1990 s.
However, even correcting for this problem, higher wealth relative to income is associated with a lower savings rate. Another source of doubt over the wealth effect is whether any observed link between wealth and spending merely reflects that the stock market picks up expectations or confidence about the future. This view is supported by one Federal Reserve Board study, which found that the confidence of shareholders and non-shareholders behaved similarly just before and during the stock market downturn of 1997, that was associated with the Asian economic crisis. However, in cautioning against reading too much into consumer confidence measures, Chairman Greenspan has stressed that what people say about their confidence and how they spend can-and has-differed (IBID). His views are supported by two new Federal Reserve studies that examine behavior across different types of households. One, found that the overall decline in the national savings rate owed to a fall in the savings rate among families in the top 40 percent of the income distribution, those most likely to own stocks, that offset a slight rise among the bottom 60 percent.
The other study found that the consumer spending of shareholders was positively associated with stock price swings, while the consumption of non-shareholders was not affected (IBID). Both studies also undermine the view that stock wealth is so highly concentrated among the top 1 to 5 percent of families that stock price declines are unlikely to affect spending. Furthermore, more households are exposed to the market, with stock ownership rates doubling from under 1/4 of households in the 1970 s to around 1/2 in the 1990 s. And also, rising stock ownership rates owe to a rise in mutual fund ownership that is linked to a plunge in equity mutual fund commission fees (3). Estimated Stock Wealth Effects on Consumption Conventional model estimates Mutual fund model estimates Boost: 200% stock wealth over '94-'99 + 5. 6 + 3.
4 Post-correction boost: 150% over '94-'01 + 4. 3 + 2. 6 Correction effect on consumption - 1. 3 - 0. 8... and consumption's direct effect on GDP - 0.
9 - 0. 5 Let me put this in context. The conventional model implies that the 200 percent rise in stock wealth posted between 1994 and 1999 bolstered consumption by roughly 5. 6 percentage points, as indicated in the top upper-left entry (Balke op. cit. pg.
2). Despite the correction, household stock wealth is still much higher than it was in the mid-1990 s, about 150 percent higher. For this reason, consumption is still being boosted by stock wealth gains since 1994 and according to the conventional model, the post correction boost is 4. 6 percent, the second from the top upper-left number (4). This implies that the correction will reduce the stock wealth boost to consumption by roughly 1.
3 percent-the third from the top lower-left entry-and the direct boost to GDP by 0. 9 percentage points According to my mutual fund model, the wealth gains posted between 1994 and 1999 bolstered consumption by roughly 3. 4 percentage points-the top upper-right number-but the post-correction boost is 2. 6 percentage points, the second upper-right entry. Thus, through the wealth effect, the correction reduces the stock wealth boost to consumption by 0. 8 percent-the third lower-right number-and the direct boost to GDP by 1/2 percent-the bottom-right corner.
In viewing these estimates, note that an economic shock, which drives down stock prices, can slow the overall economy through other channels. For example, concerns over the profitability of investment can slow GDP growth by reducing investment and labor income growth, as well as through lowering stock prices. The Real-Estate Market Real-estate prices got a boost too, as ballooning paper assets provided the backing for even bigger mortgages. Government economists estimate that this wealth effect added about one percent a year to the growth in U.
S. consumer spending. Greenspan agreed, giving a tip of his hat to the wealth effect in explaining why so many Federal Reserve interest-rate hikes appeared to have so little influence on the economy. There have been six hikes since June 1999. Still, whatever money the central bank withdrew from the economy through this process the stock market more than replaced. Since the start of the bear market, we have seen inflated real-estate prices turn south.
For example, the office real-estate market, which was booming when the Nasdaq and technology companies were prospering in the bull market, has now fallen off sharply with most of the technology sector down, bankrupt, or out of business. The IPO market is all but shutdown with no demand for any office real estate, thus dropping the price. The wealth effect, however, proved a double-edged sword for the market itself. On the one hand, consumer spending increased corporate earnings and investor profits - and margin loans on paper profits. This produced a river of cash to drive prices higher. On the other hand, economic growth rates that refused to fall ensured that the Fed would keep raising rates.
That, Wall Street knew, would eventually work against stock prices. By fueling the final blowout stage of the market rally at the same time that it was steering Greenspan to raise interest rates, the wealth effect certainly set the stage for the market sell-off that began in March. Negative Wealth Effect Now, on the downside, a negative wealth effect is creating a different set of problems for the U. S. economy, Alan Greenspan and the stock market. And just as the wealth effect prolonged the good times in the economy and for the stock market, the negative version has the potential to send economic growth lower than expected and to keep the market from moving off its 2000 lows until well into 2001 and 2002.
The negative wealth effect has certainly hit the consumer sector. With the Nasdaq Composite Index down well off its March 2000 highs, investors with technology-heavy portfolios no longer feel quite so comfortable about spending. This shows up in the University of Michigan index of consumer sentiment, which fell again in October - its third consecutive monthly decline. The previous month, an American Express poll found that households planned to spend 14 percent less on Halloween this year (5).
Retailers, the first to pick up on changing consumer attitudes, also have turned more cautious. Wal-Mart (NYSE: WMT) recently told Wall Street analysts that it expected same-store sales growth for the rest of 2001 to run between four and six percent. That's a huge drop from the nine percent growth it racked up last December. On the downside, the wealth effect produces exactly the same kind of self-reinforcing spiral it did on the upside. Now, though, instead of stock-market gains leading to higher consumer spending leading to higher corporate profits leading to stock-market gains, the order is reversed. Wal-Mart's stock is down 10 percent since it announced its lower sales projections.
This, in turn, erodes portfolio values and cuts into consumer confidence even further. Let's also not forget that the rising stock market did much for the confidence of corporate consumers, too. Backed by a climbing stock price, corporate managers had little trouble raising cash to expand their fiber-optic routes, build new stores or buy competitors. And when they did so, the stock market responded by driving the price of their shares higher. This made the money just spent seem almost free because it was so quickly replaced by the gains in the stock market.
Probably no industry exploited this more than telecommunications. Even before a company completed one fiber-optic network, it would announce initial construction of another loop. Companies hadn't begun to digest one acquisition before they launched another. Sales forces had barely identified customers for existing capacity before their companies were ordering equipment to expand capacity again. And why not? In 1999, the share price of Global Crossing (NYSE: GX) climbed 122 percent. Qwest Communications' (NYSE: Q) stock jumped 72 percent; Metro media Fiber Network's (Nasdaq: MSN), 186 percent; Sprint PCS's (NYSE: PCS), 343 percent (6).
Now, of course, the cycle is winding in the opposite direction. Take, for example, the recent experience of Global Crossing. In early October, an initial public offering of Asia Global Crossing (Nasdaq: AGC X) a spin-off of the parent company's fiber business in Asia, sold at $7 a share, far below the $14 to $16 range originally projected. Even with the clout and deep pockets of the issues underwriters, Goldman Sachs (NYSE: GS) and Salomon Smith Barney, the company was able to raise only $476 million, half of the initial target. To add insult to injury, Asia Global Crossing had to sell 28 percent more shares, thereby increasing the cost of capital to the company. These sorts of developments reduce confidence among corporate consumers even further, of course, making them less likely to spend and, in the process, setting the stage for yet another downward spin in the cycle.
This spiral will eventually come to a stop, just as it finally did on the way up. Stock prices will stabilize enough so that they won't exert much pressure on confidence, and consumers and corporations will stop cutting back their spending plans. But the blowout on the upside in 1999 and early 2000 shows the process can take a while to run its course. The negative wealth effect looks, at the moment, as though it might be with us well into the middle of next year. Conclusions There are three main conclusions that I draw.
First, while criticisms of the stock wealth effect have some validity, a careful review of the evidence implies that stock wealth does affect consumption. Second, there are several unclear effects of the stock market on businesses because the relationship between firms and the stock market has changed a lot. The plunge in venture capital investment is one example. In addition, because CEOs are held more accountable for their companies's tock prices, its unclear by how much stock price declines will induce them to cut investment and layoff workers. The third conclusion I draw is that while the conventional stock wealth effect is likely overstated, the underlying impact on consumption and on firms has likely risen over time, due to factors such as the rise of mutual funds and venture capital which have democratized America's capital markets... Between 1954 and 1994 household assets increased on average 3.
2 percent a year... But between 1994 and 1999, they jumped on average 8. 5 percent annually, adjusted for inflation -- an extraordinary increase that may well have fueled the consumer-buying binge... Experts now predict that household asset values will decline by perhaps 1 percent this year... Financial instruments such as stocks and bonds have expanded from 30 percent of total household assets in 1954 to 54 percent in 1999. The ratio of households' debts to assets stood at 8.
2 percent in 1954. By mid-2000 it had reached 14. 4 percent (Fidelity Investments op. cit.
pg. 5). A stock-market bubble exists when the value of stocks has more impact on the economy than the economy has on the value of stocks. Hot sector after hot sector in the U. S.
stock market is bursting, starting with the Internet bubble, which has already burst, and continuing with the information-technology bubble, which is now bursting. The collapse will probably spread to other sectors and could cause a U. S. recession next year -- and possibly a global recession. Overheating causes most recessions. As the economy gets stronger and grows, households and businesses spend until demand growth outruns output growth.
Prices start to rise, and the Fed pushes up interest rates and restricts liquidity until the economy slows down. Sometimes it takes a recession to convince the happy spenders to cut back, as in 1990; sometimes it just takes an economic slowdown, as in 1994 and 1995. Yet, the signs of the sharp slowdown of investment and consumption ahead have little to do with interest rates and a great deal to do with the stock market. The extraordinary rise in the U. S. stock market has been fueled by strong investment growth -- partly in the form of IRAs and 401 ks -- and productivity, coupled with rising consumption that has, in turn, relied on a zero level of savings by U.
S. households The huge wealth increases generated by rising stock prices and the attendant, though much less spectacular, increases in real estate and bond prices have increasingly led U. S. households to rely on asset appreciation to achieve their savings goals.
During 1999, wealth gains totaled $ 5. 15 trillion, while savings fell to 2. 2% of disposable income, far below the long-run average of around 7%. So far this year, wealth gains are zero or negative, and traditional savings have fallen yet again (7). But households have felt comfortable spending all their disposable income, and then some, because they achieved two years of wealth accumulation with the extraordinary rise in the stock market. Further, many appear reluctant to sell stocks and pay capital-gains taxes, preferring instead to borrow against them to finance continued spending Until a decade ago, Americans wondered at the start of each year whether the stock market would go up or down.
They saved about 7% of after-tax income to ensure that wealth would at least be maintained even if stock prices fell. By 2000, after nearly a decade of rising stock prices, Americans started the year wondering by how much the stock market would rise and saved nothing out of income, but relied instead on expected wealth gains to do their saving for them. U. S. businesses experienced a similar transformation of expectations about stock prices and undertook more aggressive spending and borrowing in 2000 as a result. An investment boom starts when a new discovery or new technology opens immense opportunities for wealth creation.
Investment growth surges, and output capacity is enhanced by more capital and greater productivity of capital. Growth accelerates, but inflation does not, thanks to higher productivity growth. The 'new economy,' with faster growth and stable or falling prices, excites investors to bid up stock prices of new-economy companies. Another round of investment follows, thanks to the low cost of capital implied by a voracious appetite for new-economy stocks. The first phase of a new economy appeared after 1995, when growth of productivity accelerated from 1% annually to nearly 3%. The second phase, after a 1998 global scare that benefited the U.
S. with lower raw-material costs and lower financing costs enhanced by a Fed rate cut, began in 1999. It crested when dot-com companies could raise billions of dollars merely by suggesting an idea about the use of the Internet. Who wanted to build a refinery when there were hundreds of dot-come in which to invest? In other words, the white-hot phase of the new economy is reached when traditional investments are starved for capital by a headlong rush into new-economy companies with seemingly limitless possibilities. Bottlenecks, like inadequate refining and drilling capacity and inadequate supplies of fuel or electric power, begin to slow the economy, just as excess capacity emerges in much of the new economy. By many accounts, the economic impact of a wealth effect could be considerable.
Credit Suisse First Boston, for example, estimates that the wealth effect added about $43 billion to consumer spending in 1999 and $22 billion last year. (Their model assumes that consumers spend around 5 cents of each extra dollar of wealth over a period of about two years). On the downside, the firm says if the Wilshire 5000 were to stay flat for the rest of 2001, the negative wealth effect of this year's dismal market performance would shave $43 billion off consumer spending, knocking roughly one percentage point off spending growth (8). The only thing worse than having too much is, apparently, not having enough of too much. On the way up, the wealth effect was a problem for the economy, Alan Greenspan and the stock market. Just as the Federal Reserve was trying to dampen growth, consumers went on a shopping spree fueled by their investment portfolios.
It is hard to determine when this bear market will end and when we will start seeing a positive wealth effect again. Some analysts are predicting a turn around as soon as Q'2 of 2002, but others are not being as bullish, stating that the market will need at least three years before we see steady improvement. The market has been very difficult for investors in the past two years, with all the negative earnings and companies going bankrupt. With that in mind, we also have to include the recent events that took place on September 11 th.
These terrorist attacks had a major impact on our economy and on the stock market. We saw a major sell off where the Dow Jones Industrial average and the Nasdaq Composite fell almost 20% each in the following weeks. The war on terrorism not only has an effect on our economy, it also has a psychological effect on investors and traders, investors may not have great confidence in the market, due to the fact that they may be hesitant to invest in the market thinking that another terrible event may occur. This event may indeed lengthen our nations bear market if we remain at war for a long time in the future. We have seen in the past month, steady gains in the major stock indices. Some are stating that the bull market may be back with the war on terrorism going well, and others are insisting that the gains are only short term and that the market will retest the lows hit in mid-September.
Only time will tell on how long it will take for our market to completely rebound into a bull market like we saw in the 90's. Sources 1. ) Balke, Nathan. "The Economy in Action." Federal Reserve Bank of Dallas. 2.
) Angeletos, George, David Laibson, Andrea Repetto, Jeremy Tobacman, and Stephen Weinberg. The Hyperbolic Buffer Stock Model. 3 March 2001. 3. ) Clarke, Graham and Steven Caldwell.
"Wealth in America." Ohio State 1998. 4. ) Fidelity Investments. 2001 Estimated Stock Wealth Effects on Consumption. 5. ) American Express Company.
2001 American Express "ever day spending" survey. 6. ) John Khoury. Yahoo Finance: web) U. S. Census Bureau.
web 2001. 8. ) Swanson, KC. Is the "negative wealth" effect all its cracked up to be. The Street. com 29 March 2001..