Wealth Effect and the Economy

Wealth Effect and the Economy

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The “wealth effect” is the premise that consumers tend to spend more when broadly-held assets like real estate and stocks are rising. The notion that the wealth effect spurs personal consumption makes sense intuitively. Anyone who owns a home or contributes to a 401(k) plan might be inclined to splurge on a big-screen TV or an SUV while sitting on huge profits, even if those profits are only on paper.

Not so fast, say some experts, who say that housing gains produce a wealth effect but stock market gains do not.

KEY TAKEAWAYS

• The wealth effect suggests that people spend more when stocks and housing prices are up.
• That is, they feel wealthier and more optimistic, even if they personally aren't profiting or are profiting only on paper.
• A word to the wise: When times are good, focus on wealth creation and preservation and avoid over-spending and over-borrowing.

Regardless of whether it is caused by real estate or the stock market, the lesson from history is that investors should treat the wealth effect with caution, since spending?unrealized gains?that may be susceptible to reversals is seldom a good idea.

Housing vs. Stock Market Wealth Effect?

One of the most widely cited papers on the comparative wealth effect of the stock market versus the housing market was written by economic luminaries Karl Case, Robert Shiller (developers of the Case-Shiller home price indices), and John Quigley. Their paper, “Comparing Wealth Effects: The Stock Market versus the Housing Market,” was first presented in July 2001 and updated in 2005, when it attracted widespread attention due to the housing boom.

Case, Shiller, and Quigley said their research for the period from 1982 to 1999 found “at best weak evidence” of a stock market wealth effect, but strong evidence that variations in housing market wealth have important effects upon consumption.

They concluded that changes in housing prices should be considered to have a larger and more important impact than changes in equity prices in influencing consumption in the U.S. and other developed nations.

House Price Slump Causes Consumption Decrease

The authors updated their research in a?new paper?released in January 2013, in which they extended their study of wealth and consumer spending to a 37-year period, from 1975 to the second quarter of 2012. Case, Shiller, and Quigley said that their extended data analysis showed that house price declines stimulate large and significant decreases in household spending.

Specifically, an increase in housing wealth similar to the rise between 2001 and 2005 boost household spending by a total of about 4.3% over the four years. Conversely, a drop in housing wealth comparable to the crash between 2005 and 2009 would cause a spending drop of about 3.5%.

Wealth Effect Skeptics

In a June 2009 working paper, three American economists, including Charles W. Calomiris?of?Columbia University,?Stanley D. Longhofer,?and?William Miles?of?Wichita State University, argued that the wealth effect of housing has been overstated and that the reaction of consumption to housing wealth changes is probably very small.

Disputing the conclusions by Case, Shiller, and Quigley, the article said that the authors failed to take account of a “simultaneity problem,” which refers to the possibility that both consumption and housing prices were driven by changes in expected future income.

When the economists used statistical techniques to the data to correct for the simultaneity problem, they found no housing wealth effect.

Interestingly, in a few cases where the economists found that housing wealth did have an impact on consumer spending, the impact was always smaller in magnitude than that shown from stock wealth. This is contrary to the findings by Case, Shiller, and Quigley.

The Housing ATM

Detractors notwithstanding, the existence of a housing wealth effect can be verified by the spending spree that millions of U.S. homeowners indulged in during the first decade of this millennium.

However, these consumers weren't sitting on paper profits. They cashed them in by taking out home equity loans.

The consumption binge of the 1990s and early 2000s was fueled largely by equity extraction from residences. Homeowners went on a spending spree using money from home equity loans, in essence using their homes as automated teller machines (ATMs).

According to a 2007 study by the Federal Reserve Board, equity extracted from homes was used to finance an average of about $66 billion in spending from 1991 to 2005, or about 1% of total PCE. While equity extraction financed an average of 0.6% of total PCE from 1991 to 2000, that share rose to 1.68% from 2001 to 2005 as housing boomed.

Mark Zandi, chief economist at Moody’s Analytics, estimates that before the 2008-09 financial crisis, every $1 increase in housing wealth produced $0.08 in extra spending, while every $1 in stock wealth gains boosted spending only by $0.03.?Zandi estimates that in the 2013 slow-growth economy, the wealth effect of housing and stocks dropped to about $0.05 and $0.02 cents, respectively

Don't let the "Wealth Effect" Crush Your Wealth

U.S. household wealth?rose by $1.92 trillion in the third quarter of 2013 to a record $77.3 trillion, buoyed by surging stock markets and a rebound in housing. Household net worth rose to more than $8 trillion above the pre-recession peak of $69 trillion, reached in 2007. It has risen consistently since then, reaching $112 trillion in the second quarter of 2020, according to figures from the St. Louis Fed.

If you do not feel especially wealthy despite that stellar performance, you are not alone. Here are some pointers for coping with the effect of the “wealth effect” on your personal wealth.

Focus on Wealth Creation and Preservation

Your focus should be on creating wealth during positive wealth effect periods and preserving wealth during negative wealth effect periods. But such wealth creation and preservation should be attempted in a measured manner, not by taking an inordinate degree of risk.

Avoid Aggressive Tactics When Markets Are Hot

Extracting equity from your home to spend on a vacation or buy stocks is generally not a good idea. Period.

As we learned in 2008-2009, paper wealth has a disturbing habit of disappearing into thin air. In other words, prices go down as well as up.

Don't Be Swayed by Get Rich Quick Tales

Speculators who attempted to day trade stocks on a big scale in the late 1990s faced financial ruin when the market crashed in 2001-02. Real estate investors who snapped up multiple properties faced a similar fate when the U.S. real estate market endured its steepest correction since the 1930s Depression during 2008-2009.

Tune out the bragging by those who profess to have made it big by (excessive) speculation, and refrain from using more leverage than your finances can comfortably handle.

Don’t Fight the Trend

The easiest way to create wealth is by staying with the trend. Being a contrarian can pay off sometimes, but if your timing is off you may have to bear sizeable losses.

As an example, short-sellers who were skeptical about the relentless advance in most U.S. stocks in 2013 had little choice but to abandon their short positions after incurring huge losses.

Pay Attention to Wealth Preservation

Wealth creation is only half the equation; wealth preservation is the other half.

If you are concerned about the possibility of an imminent steep correction in the markets, use trailing stops and option strategies to protect your gains.

Stay Attuned to Valuations and Signals

Valuations and other signals can provide an early warning of an impending turnaround in investor sentiment.

While it is difficult or impossible to pinpoint market tops and bottoms, simple strategies like taking some money off the table when they hit record highs and adding quality companies at multi-year lows are sound tactics for wealth creation.