The Wealth Effect: The Virtuous Cycle and the Vicious Circle By: Gabriel PotterMBA, AIFA® 2013.11.27

It has been a stellar year for investors and that may finally yield some advantages for consumer confidence and promote traction in consumer spending.  Why?  It’s called the Wealth Effect theory.

Imagine your frugal next neighbor wins a million dollars in a lottery; you wouldn’t be surprised to find a luxury car in your neighbor’s driveway, right?  Your neighbor has cash in hand, so they can afford a frivolous luxury item, and they do so.  Similarly, if assets you already own – your house, your investments, your business – increase in value, you become more comfortable with spending.  That’s the trick of the Wealth Effect:  an unrealized gain – for example, the  increased value of your stock portfolio valuation – can be as powerful as tangible dollars to change your behavior.  Aggregate increases in spending can increase economic activity and corporate earnings, often justifying increased stock prices.  Thus, there is a virtuous circle of consumer confidence and the real economy.

Dr. David Kelly of JP Morgan has noted that the net worth of the US has improved by about $12 trillion dollars through September 2013; that number is assuredly higher now, given the all time highs we are seeing this week in the S&P 500.  By comparison, the entire deficit – which has generated so much pain and discord during the past few years –  is only $16 trillion.  Americans could neutralize the debt to essentially nothing using only the market gains of 2013. 

Of course, the wealth effect works in both directions.  If the stock market is going down, people feel less free to spend, so they hold back.  Economic activity and earnings go down, and so stock valuations appear stretched.  Investors worry that they are overpaying for the earnings being generated by a company and sell their stakes, putting downward pressure on stock prices as demand falls, and vicious circle continues downward. 

It’s like a “bank run”:  if depositors become afraid of a bank, no matter how healthy or well-run, becoming insolvent at the same instant, they could all withdrawal their money at the same time.  Once that happens, the bank really will lose their ability to redeem everyone’s cash in a timely way, thus demonstrating the truth in the fear.  In other words, the absence of confidence can have real world consequences and the perception of reality often dictates reality.  Confidence is good for the real economy and there are clear political and economic reasons to maintain it. 

In theory, it is improbably simple to create a positive Wealth Effect if you have a centralized monetary system.  The Federal Reserve could print money out of thin-air, increasing the numeric value of assets, trying to generate a virtuous cycle of spending and maintain confidence in the system.  Critics of the Federal reserve would charge that an unchecked Fed, under political pressure from politicians anxious for positive GDP growth, could go too far trying to boost confidence by printing essentially worthless dollars, and thereby generate runaway inflation.

Long time readers will note that the proof of the Federal Reserve’s efficacy comes down to core inflation numbers.  The November 2013 inflation numbers are due on December 17th, and we’ll be curious if the recent stock market highs are elevating prices for other goods and services.

For more about the Federal Reserve and what they do to maintain price stability in the wake of these complicated and interconnected factors, please read  our February 2012 article, “Recent Changes at the Federal Reserve.”

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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