OCTOBER 19, 2000
NEWS ANALYSIS
By Michael Englund, S&P
Will a Swooning Market Put the "Wealth Effect" in Reverse? | Not likely. Sure, stocks are down -- but nowhere near enough to wipe out the massive and diversified gains of the Nineties
| With the ongoing sell-off in the U.S. stock market, economists are again citing "negative wealth effects" as a reason to expect a near-term slowdown in consumer spending. That would be the reverse of the much talked-about wealth effect that so many economists give much credit for fueling this expansion. Since so many Americans have made so much (at least on paper) in the stock market boom, it's no wonder they've been such big spenders.
But as we argued at the time of the stock market corrections in 1997 and 1998 -- and during the 1987 correction, for that matter -- downward movements in stock prices at the end of large stock-market rallies shouldn't be expected to have sizable negative effects on consumer outlays.
To understand why, a little perspective helps. The stock market rallies of recent years have dwarfed the size of ensuing corrections. And household wealth is not concentrated in stocks alone, but dispersed
across a wide range of assets. Finally, most households do not link monthly spending decisions to monthly stock market performance.
FAMILIAR ROAD. Though the correction in the U.S. stock market in 2000 may seem painful, it must be remembered that these losses follow a string of five years of spectacular gains. If we use the Federal Reserve's annual and quarterly data on household wealth and its components to gauge wealth effects and their likely impact on spending, the relative magnitudes of the wealth gains of the 1994-99 period vs. the "pause" in wealth gains in 2000 can be readily seen.
The value of direct U.S. household holdings of equities rose 280% from 1994 to 1999, vs. a gain in nominal gross domestic product of 32% over the period, and a gain for household spending of 33%. If the value of equity holdings is to drop back in 2000 to the ratio to GDP or consumption seen in 1994, we would need to see a humongous 63% equity market sell-off. In short, households have only "spent" a small fraction of the recent stock market gains they experienced through direct holdings, so a correction in 2000 should have a limited impact as well.
The above numbers measure only "direct" equity holdings, which constitute 16% of household wealth, but the same point can be made for more broad measures of assets. Indeed, if we use "total household
wealth" as our parameter, this measure increased 71% from 1994 to 1999, or nearly twice as much as GDP. This aggregate would need to drop by 18% in 2000 to return to the ratio to GDP seen in 1994. Such a drop for this more stable measure is even more unlikely than the 63% decline that would bring direct holdings back to their 1994 GDP ratio.
WIDESPREAD ASSETS. The reason for the big discrepancy between growth in household wealth and the gain in direct stock holdings since 1994 is that household wealth is distributed across a broad array of asset categories. As of mid-2000, 45% of household wealth was held in the form of tangible assets, deposits at banks, credit-market instruments, life insurance reserves, and miscellaneous assets. For these asset categories, 2000 has been a fairly good year, particularly for the sizable real estate category (a large tangible subcomponent), which rose at a 7.8% rate through the first half and which constitutes a hefty 23% of household wealth.
Our final point is that households hold most of their equities in the form of pension funds (20%), ownership of small, noncorporate businesses (10%), and mutual funds (16%). Swings in these values are often dampened via hedging, these assets are sometimes illiquid, their prices are sometimes unobservable, and they are viewed as long-term investments.
As such, gains or losses for these components probably have a limited impact on monthly gyrations in the behavior of most consumers.
Englund is chief market economist at Standard & Poor's
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Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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