The Wealth Effect

March 22, 2013

This is one of those cool academic ideas that resonate with non-academics. If you’re an armchair economist you’ll nod and say, “oh yeah” when you read about it. I’m talking about the wealth effect. The wealth effect is the change in consumers’ attitude and spending behavior caused by the perception of increased wealth.

When a 10% tax hike to pay for the Vietnam War failed to slow consumer spending in 1968, economists attributed the behavior to the wealth effect. Disposable income actually fell, but paper wealth was rising sharply with the stock market, and consumers continued to spend.

We’re living through a good example right now. Most economists expected the January 1, 2013 2% tax hike from elimination of the temporary Social Security tax cut to reduce consumer spending because of reduced disposable income. It hasn’t, and the most likely cause is the current rebound in the housing market and the rise of stock prices; this may be leading consumers to feel more secure with their personal finances and ultimately spend more.

It’s important to note that the concept is that perception of increasing wealth trumps the reality of declining income. Don’t confuse the wealth effect with Alan Greenspan’s “irrational exuberance” which was fueled by a real increase in disposable income based largely on the housing bubble.

Of course, a rising stock market that goes on long enough should eventually lead to increased business confidence, hiring, falling unemployment, and a rise in disposable income. That would be great, because then we won’t be depending on perception, but on real prosperity.

 


The New Milestone

March 12, 2013

The Dow Jones Industrial Average rose above its all-time intraday and closing highs on March 5, ending at 14,253.77. That’s more than 100 points above the 14,164.53 record it hit in October 2007 before the Great Recession. The almost-four-year bull market is the eighth longest in the last 100 years, and the sixth strongest in terms of the return of the S&P 500.

Wow! So what? Or something in between? Here are some perspectives on the market for the long-term investor.

This upward trend for the markets continues against a backdrop of monetary policy decisions and continuous (albeit slow) economic growth. The Fed and other central banks continue to pursue a policy of easy money and low interest rates, and economic growth is unspectacular but solid: corporate earnings and dividends are rising, the U.S. housing market is growing, the unemployment rate is gradually declining, and the auto industry is healthy again.

Low interest rates and low bond yields mean investors seeking income are increasingly turning to stocks. And periodic reminders of continued weakness in the euro zone, like the recent Italian elections, give investors worldwide a reason to move money into the United States. Demand increases price, so the Dow is rising.

Now for two reality checks.

First, since the end of 1994 and the beginning of the 1990s stock boom, consumer prices have risen 55%. The Dow has more than doubled since 1994, but after adjusting for that 55% inflation, it shows no gains since the first part of 1999. Investors planning for retirement have to remember that ignoring inflation overstates the value of future investments and understates the amount of money needed for retirement. Second, the four-year bull market and the “lost decade” that preceded it yielded a total return on stocks less than half the historical norm.

And a reminder.

There’s still a lot of money sitting on the sidelines, and a lot of people who are getting ready to jump in. If you’re one of them, remember that a new all-time high is just a number, so don’t get swept up in an emotional reaction to highs or lows.

The fundamental things apply as time goes by, the first of which is that even the pros can’t time the markets in the short term. You should have a long-term plan that integrates your investments, savings, taxes and risk management. Adjust it periodically as markets and the economy warrant. And, stay invested because investments work; investors don’t.

 

The Dow Jones Industrial Average is an unmanaged index which cannot be invested into directly.  Past performance is no guarantee of future results.

 


Headwinds and Tailwinds

March 1, 2013

One pundit, and he’s not alone, said at the end of last week that “tailwinds we had at the end of the 4th quarter 2012 and into 1st quarter 2013 may be disappearing and turning into headwinds.”

Really?

The long-term trends on unemployment, hiring and housing are all positive. The Fed remains committed to a long-term easy money policy. The 4th quarter’s 0.1% contraction is likely to disappear when revised GDP numbers come out next week. Steadily rising auto sales and wage concessions from labor are leading to new manufacturing investments and hiring by the three Detroit automakers. And even with a bad two days last week when Fed minutes revealed disagreement over how long to keep buying bonds, the markets remain strongly positive for the year. Those are the tailwinds, and while they’re not fabulous, they’re good.

The headwinds, however, are definitely blowing.

The sequester now appears inevitable, but opinions about the consequences of cutting $85B at one stroke vary widely. Some economists think it could send the economy into recession. Others predict it will cut 2013 GDP growth from 2.6% to 2.0% and cost 700,000 jobs. And the most sanguine contrarians point out that similar government cutbacks in recent years have been anything but catastrophic, and the economy is strong enough to weather the blow. Wherever one falls on the spectrum of sequester seriousness, uncertainty about it is weighing on consumer confidence, as are higher gas prices and the end of the 2% cut in the payroll tax, the functional equivalent of a pay cut. Remember that consumer confidence drives consumer spending, and that consumer spending is the biggest single driver of the economy.

Europe is our largest trading partner; the European Union is warning that its economy will shrink for the second year in a row in 2013, and that France and Spain will miss fiscal targets designed to ensure stability of the Euro. For the first time since 2009, the combined GDP of 34 major developed countries is shrinking, indicating widespread weakness. A major reason for the decline, and for the weakness of the recovery from the Great Recession, is the decline in government spending. During the first decade of the 21st century, government spending in the Euro zone and the U.S. grew every year. Budget cutting at all levels of government is now epidemic in the U.S.; austerity is now the norm in Europe.

As always, your best strategy in the face of winds from any direction, and from the unpredictability of the markets in the short term, is a portfolio diversified by both asset class and risk. And a determination to remain invested for the long term, without being swayed by emotion.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.