Paper Losses May Add Up

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Brimming with confidence, the American consumer - as we've documented in previous issues - has been on a tear, purchasing record numbers of automobiles, appliances, recreational vehicles, and other big-ticket durable goods. But how much of the current spending spree relies on confidence derived from recent stock market gains? Many market observers fear that the next bear market, when it comes, will have a much more severe impact on economic activity than in the past because of the extent to which individuals' fortunes are tied to the stock market's ups and downs.

A robust market is directly responsible for healthy paychecks - certainly for many people in the financial services industry. As the aggregate value of equities increases, so too do transaction and management fees, boosting the compensation of a multitude of bankers, brokers, and portfolio managers. What's more, linking compensation to stock performance has become increasingly popular, causing a proliferation of equity incentive packages and option awards.

Then there is the "wealth effect." Economists have been arguing about its existence for decades, and even supporters can't seem to agree how significant it is - or how to measure it. The theory is that when household wealth increases, consumers gain confidence and become more comfortable with levels of spending - sometimes financed by debt - that exceed their earned income. In a study published by the Federal Reserve Board in 1996, it was estimated that consumers spend an incremental $0.03 each year for each dollar's increase in stock held. While that portion may seem modest, consider that participation rates in the stock market have been rocketing: Now, more than 40 percent of households own stocks in some form, and it's estimated that two-thirds of the aggregate value of stocks in the U.S. - some $8 trillion - is controlled by households, including directly held equities and equities held through mutual funds and defined-contribution pension plans. (The top 5 percentile by net worth controls 68 percent of household stock owned, according to a 1995 Federal Reserve survey of consumer finances.) At least 1 percentage point of the growth in inflation-adjusted gross domestic product over the past three years can be attributed to consumption driven largely by asset gains, says Fed chairman Alan Greenspan.

Obviously, it is the affluent households that play the biggest role in the aggregate wealth effect. Stockowners with holdings above $250,000 - roughly the top 10 percent - are more likely to let changing portfolio values affect their spending attitudes, according to a recent survey of consumers by the University of Michigan, whereas most other households view stock investments as long-term holdings, irrelevant to consumption patterns. These results support the notion that upscale products may be more sensitive to stock market performance than average. Meanwhile, economists theorize that age, too, can increase the tendency to spend according to wealth changes. So the wealth effect may be becoming more pronounced as boomers age.

This spring's sharp correction among most of the previously high-flying Internet stocks is likely to curtail consumer impulse purchases in coming months. Consider that the slashing of America Online's share price by 50 percent during April and May caused paper losses of almost $100 billion. Using the Fed's wealth-effect estimate of 3 percent, that's $3 billion in lost spending.

Advertising expenditures, fueled by new media opportunities on the Internet, have recently reached new highs. But a significant stock market sell-off may change this suddenly. With concerns regarding this possibility being voiced from levels as high as the top of the Fed, the implications of such an event certainly warrant some forethought.

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