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What If the Market Takes Back What It Has Given? Americans' wealth is tied like never before to equities. And that raises some tough questions What could have been more nurturing than the stock market of the 1990s? It's user-friendly: You can trade online from your living room. It's generous: From 1995 to 1998, the S&P 500 yielded an average annual gain of 30%, vs. 9% for the previous 24 years. It's bountiful: Thanks to the market, average Americans are wealthier than ever -- and using their windfalls to buy sport-utes, college educations, retirement homes, and, of course, Net IPOs. The market is an indulgent parent and a winning lottery ticket, all in one. It's no surprise, then, that more and more Americans are pillowing their heads on the market's broad bosom. From 1994 to 1999, total equity holdings of U.S. households more than doubled, to $10 trillion, according to a recent New York Federal Reserve Bank report. About 50% of U.S. households now own stock, according to a Securities Industry Assn./Investment Company Institute study released in October, up from 19% in 1983. And these aren't just rich people. The median household income of individual investors is $60,000, their median age is 47, and their median household financial assets, excluding the value of their homes, total about $85,000. Some 58% of those nonhome assets are in stocks -- a percentage that has quadrupled since 1989. One-third of those assets are in retirement plans of one sort or another. But even setting those aside, the share of individuals' nonhome assets that are tied up in the market has nearly tripled in a decade. As Wall Street likes to say, Wall Street has come to Main Street. MEGATON POWER. More than ever before, in fact, the market is a pillar of the U.S. economy. By giving venture capitalists a sure-fire way to cash out, it has stimulated the investment that has made possible America's world-leading role in the Internet -- and perhaps the Net itself. In so doing, the market has helped finance a surge in technological innovation unmatched since the days of the Robber Barons. Moreover, the market has grabbed a prominent role in compensation, letting employers reward workers -- and indirectly bolster consumer spending -- without the outsize wage hikes that set off inflation alarms. One-third of employers now offer stock options to nonexecutives, notes Joel Prakken, chairman of Macroeconomic Advisers in St. Louis, the former firm of Federal Reserve Bank Governor Laurence Meyer. A study by compensation consultants Watson & Wyatt Worldwide shows that 19% of all U.S. employees were eligible for stock options in 1999, compared with 12% in 1998. At no time in U.S. history -- except, perhaps, during the 1920s -- has the stock market meant so much to so many. And that could be a problem. If both wage earners and the economy depend more on the market than ever before, they are also more exposed than before to its vicissitudes. Granted, everyone knows that the market fluctuates. But today, those fluctuations could have a larger, more direct economic impact than they did even a decade ago. That raises intriguing questions, which gain in urgency as the bull market ages: For all its beneficence, for example, how much risk has the market added to the economy and to individual households? And will the economy and investors be ready to deal with that risk when the inevitable market downturn occurs? An equally pressing question is this: If the multi-tentacled market retreats significantly, will policymakers be smart enough to make sure moves? LEFT TO GUESS. Increasingly, that question is on the minds of corporate, Street, and Fed economists. Because the market now reaches so deep into the economy, "if it goes into a sharp correction, we can't use traditional relationships [between the market and consumer spending] to predict what will happen," says Stephen Roach, chief economist and director of global economic analysis at Morgan Stanley Dean Witter & Co. "People like me will just have to guess." Such concerns may be the last thing on the minds of most investors. The $10 trillion in stocks and mutual funds held by households amounts to about $76,000 per household. A family with a $60,000 income, saving at the once-normal rate of 8% a year and earning 6% interest compounded monthly, would need 11 years to amass that amount. Yet even as market players count their blessings, economists are counting the days until the party ends. "The National Association for Business Economics [a nonprofit group] did a poll of 181 U.S. economists last July, in which it asked the experts what they thought was the single biggest problem facing the U.S. economy," notes Steven Wieting, equities economist at Salomon Smith Barney (SSB). "You know what they said? The single biggest problem facing the U.S. economy is a stock market bubble. They ranked that higher than poverty." HORMONE SHOT. It's true that in recent times the Fed has handled each problem the market has tossed it with aplomb. In the scariest plunge in recent decades -- the mini-meltdown of 1987 -- the Dow's 23% single-day decline had a muted effect on the economy partly because a small percentage of households had their wealth tied up in stocks. What saved the day, though, was the testosterone injection the Fed immediately administered in the form of lower interest rates. The rate cuts boosted consumer confidence well before there could be any damage from the "wealth effect" -- the tendency of investors to increase or reduce household spending as their wealth rises or declines. The Fed would act similarly in another meltdown, of course. But would its remedies work? With interest rates already low, even a huge percentage cut next time might amount to only a point or two -- and fail to create a correspondingly strong stimulus. And any Fed move could be partially offset by the marriage of individuals to the market. Certainly, that marriage is a strong one for employees who count on stock options for income. For now, having compensation tied to their company's performance is a plus for most employees. And employers who grant options often do so to control labor costs. SMALLER STASHES. Still, options won't be so appealing to workers in a market decline. The downside already shows up as lower morale and higher turnover in dot.com companies whose stocks are "under water" -- selling lower than the price at which they went public. Moreover, options hurt the Fed's ability to tell what's happening to pay, since options are only partially accounted for in the Fed's calculation of wages. In theory, this means that the old market-killer, inflation, could spring to life before the Fed can take measures to contain it. "Stock options make it harder to read inflationary tea leaves," says Prakken. Some economists also see as ominous the market's new role as a repository for savings. For instance, government statistics show that the individual savings rate -- income that people stash away -- has plummeted from 8% at the beginning of the decade to 2% currently. Macroeconomic Advisers has pinpointed the cause as the stock market. Instead of putting aside a bit of each paycheck for a rainy day, many people are buying stock. They let appreciation in those shares create savings for them while they spend their salaries on cars or computers, videos or vacations. "We can almost fully explain the drop in the savings rate with the increase in stock market wealth," says Prakken. As long as the market booms, there's no problem: Wealth will rise, at a fast clip. But what if the market slides? The effect would depend a lot on how much, and for how long. And the individual impact would vary significantly depending on how long investors had been in the market and how large their gains were. But a market letdown that laid waste to what may be America's No. 1 reservoir of savings would be a big deal: Savings translate into care for the elderly, maternity leave, an education, a bigger house for when the new baby or grandma shows up. Americans pay for these as well as all manner of personal disasters themselves. And if Macroeconomic Advisers' interpretation is correct, the money they've earmarked for such uses is now tied up in the market. NOT ENOUGH DATA. For these investors, a market crisis could equal the disappearance of a CD or a savings account. How pervasive would the impact be? "We don't have enough data" to predict, says Sydney Ludvigson, an economist at the Federal Reserve Bank of New York, who in July published a study of this issue with Charles Steindel, a New York Fed senior vice-president. That paper, entitled "How Important Is the Stock Market Effect on Consumption?" suggested that the effect of market fluctuations on consumer spending would be small. Still, "it could be years before we have the data" to say so definitively, Ludvigson adds. And economic and market cycles could come and go in the meantime. One theory economists are revisiting to help them understand the market's clout is the "wealth effect" that Nobel Prize winner Franco Modigliani postulated in the 1950s. Simplistically, his idea was that if wealth increases, people buy more; if it decreases, they buy less. If they buy a lot less, you get a recession, or worse. Modigliani's research showed that for every $1 of new wealth, people spend about five cents more and vice-versa. Ludvigson and Steindel's New York Fed study pegs the effect at three to four cents per dollar gained or lost. That sounds small, but figured on $10 trillion in U.S. household investments, it's $300 billion to $400 billion -- spending that could depress the economy if it suddenly disappeared. The key words there are "if" and "suddenly." "Modigliani just said 'wealth', he didn't say what kind," observes Macroeconomic Advisers' Prakken. The distinction is important, he adds, because people treat stock gains differently than other kinds of wealth. "They know it's more volatile, so they wait to convince themselves that it's permanent [before they start spending]." In his model of the economy, there is a two or three year lag before increased market wealth boosts consumption. His model has been tested only in a bull market, however, so it's unclear what the effect could be if the bear comes out of its den. That could shorten the lag time until spending drops, for instance. HOW SENSITIVE? Could the lag be so short as to induce a panic? Nobody knows, because there are few precedents for how today's middle class will react if its wealth -- even if it's just paper gains in a portfolio -- starts to vanish. Some economists point to the recovery from the 1998 market dip to show that people will ride out the storm. But typically, economists don't all agree. "Households with $50 million-plus in wealth aren't excessively sensitive to stock market fluctuations. It takes a very big move to have much of an effect in their spending," says Gary Burtless, economist at the Brookings Institution. "But now there are a lot more people with wealth in the $50,000 to $200,000 range. To the extent they own stock directly, the middle class may be more responsive to the value of their holdings." The opposite argument comes from University of Chicago supply-side economist Milton Friedman via his controversial (in economic circles) theory of permanent income. Basically, Friedman's theory says that people react the same way to shifts in income whether they're rich or poor -- with both groups increasing or cutting their spending by about the same percentage their wealth rises or falls. If Friedman's theory is right, then a market slide that doesn't roil the rich shouldn't disturb the middle class much, either. If he's wrong -- given the increased stock holdings of the middle class -- the next market slide could disprove his theory. MORE RESPONSIBILITY. The overriding question, of course, is: Should investors get out of the market now, before it's too late? At this point, probably not. For one thing, most people can't afford to. "Given their retirement expectations and the need to fund their kids' education, [individual investors] need exposure to the equity markets to keep up with inflation and not settle for the historic underperformance of bonds vs. the equity markets," says Scott Kursman, assistant general counsel for the Securities Industry Assn. The need to invest has grown over the past two decades as companies have switched from defined-benefit pension plans -- which obligated an employer to make good on a retiree's income -- to defined-contribution plans, which give chunks of money to employees and tell them to manage it, within certain bounds. For individuals, one byproduct of having more access (and exposure) to the markets is having to take more responsibility for managing their own finances. Striking the right balance between need and greed is up to each person. The safest route is probably to follow sound investing principles -- balance your portfolio between conservative investments, such as bonds and blue-chip stocks on the one hand, and riskier stocks on the other. It also means planning ahead to cash out the part of your portfolio that's needed for an immediate expense: Switch a college fund to something less volatile as the need draws near, for instance, or move a bigger share of your portfolio into income-producing bonds when you turn 65. SOCIETY OF SHAREHOLDERS. As investors wrestle with such decisions, economists need to find ways other than historical precedent to manage a stock market-centric economy. Not that they aren't looking at the issue: Ludvigson and Steindel's study shows that the Fed is taking it seriously -- but even their findings are based on what has happened in the past. Economic forecasting models need to better analyze the relationships between Fed policy, the stock market, and the calculation of inflation, all of which have changed in today's equities culture. Indeed, prominent economic forecasters are trying to solve this riddle. It's also important to recognize that the changes the market has wrought may not be bad -- they may simply need to be understood. In fact, the 1990s are a compelling argument for creating a society of shareholders. Still, it would be folly to assume that the market can rise forever. And it would be wise to understand the ramifications before the next bear market arrives. "It's clear that financial assets and the real economy are linked as never before," says Morgan Stanley Dean Witter's Roach. If that's so, then economists and policymakers should be retooling their practices to fit a world in which equities are king. By Margaret Popper in New York _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ |
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