[Note: This post is for education and entertainment only. Investment decisions should be made on the basis of suitability and risk tolerance and with the help of a professional.]

Investors and planners should be aware of an important phenomenon called the “wealth effect.” The wealth effect occurs when asset prices rise, causing investors, savers, or property owners to feel wealthier. As a consequence of feeling more secure, they revise their spending and business investment budgets higher. Those higher levels then drive jobs, earnings, and asset prices still higher and the process feeds on itself.

Sound simple? It is.
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When asset prices go down, however, the wealth effect works in reverse: people don’t feel as wealthy, they don’t spend as much, corporate profits go down, and the process begins to feed on itself as a mirror image of the process on the way up[/pullquote]
In fact it’s very fast-acting and what’s more, the Federal Reserve Bank has been relying on it now for two decades to make the economy grow. Through a combination of lower interest-rates and aggressive injections of capital into the financial system, they caused stocks and bonds and real estate all to rise—thus raising GDP. The only problem with wealth affect growth however, is that it relies on continued stimulus–in other words, it’s unsustainable (for too many reasons to note here—but not least that it furthers wealth inequality).

I am getting to my point.

When asset prices go down, the wealth effect works in reverse: people don’t feel as wealthy, they don’t spend as much; corporate profits go down, and the process begins to feed on itself as a mirror image of the process on the way up–but it is perhaps faster-acting in reverse because the “up” process implies taking on more debt, and also because fear is thought to more powerful in mass psychology than greed.

Right now, with the S&P500 index down 10% or so in the first few weeks of the year, there’s great risk that businesses will downsize, trim forecasts, and announce layoffs. Municipal budgets could get trimmed, too. When asset prices fall, it causes underfunded pensions (caused by poor investment returns) and it implies lower tax revenues from property, sales, or income tax. And of course we have the consumer. When the quarterly statements reflect a downward trend, the average investor projects that trend onto their spending habits—subconsciously or otherwise.

Little of what I’ve begun with in this expose’ is new as a concept to most economists or financial professionals. Most economists downplay this fast-acting and powerful “effect.” The part that needs discussion is the fact that the wealth effect behaves very much like leverage. In a sense, the wealth effect is psychological or emotional leverage. And it can be just as damaging as balance-sheet leverage because the entire financial system is founded upon confidence. If you read my reviews of “The Big Short,” and some of my other posts about the stock market, you know that debt is an insidious tool – especially when things go bad. Wealth effect, or emotional leverage, gets particularly bad when it triggers a “panic.” By definition, panics are irrational, but they can cause severe damage while they are in play. For example in 1932, as a response to mass deposit withdrawals, FDR declared a “bank hoIiday” and closed the nation’s banks for five days–this practically hours after he delivered his famous “nothing to fear but fear itself” address.

With that in mind and in the context of the topic, investors should fear the wealth effect as a negative driver in the economy, and have a healthy fear of fear itself.

WH