For the thread:
Give Me A Break: The poverty effect explained
By Brett Klasko
investorsalley.com
While the latest boom in this robust economy of the United States for the past eight years has produced many great things, including tremendous growth, both for businesses and consumers, there are problems that cannot be overlooked.
You’ve all probably heard economists comparing our current economy to that of the 1920’s and warning that we are doomed for a serious recession or even a depression. While there are similarities between the two economic periods, one must keep in mind the various programs implemented to prevent a dire depression, including the Federal Reserve -- believe it or not, they don’t just meet occasionally to look at interest rates -- and social security -- which Gore (lock box) and Bush (give it to the teens) fought over.
My point? These are just some of the programs one must keep in mind that are set to prevent any repeat of the Great Depression.
Recessions? Sure, we can have them.
It’s just part of the business cycle. BUT, that does NOT mean that each recession will lead to a depression. Rather, small recessions (which some analysts think we are in now) can create tremendous buying opportunities in the stock market, which will bring us right back out of the recession.
What comes with a boom in the economy?
Why, I’m glad you asked.
Booms in the economy, and thus gains in the stock market, usually lead to a relatively new phrase coined the “wealth effect”. The so-called wealth effect (a.k.a. the real-balances effect) is, technically speaking, the tendency for increases in the price level to lower the real value (or purchasing power) of financial assets with fixed money value and, as a result, to reduce total spending. The converse applies to decreases in the price level.
Confused? Good, so am I.
Now, for the layman’s definition… The wealth effect is, in essence, a feeling of over-confidence by consumers. The wealth effect occurs when consumers spend money they do not have at the time, in anticipation that they will see that money in the near future. Basically, consumers can see an increase in their stocks or any other financial asset, and then turn around and spend that money. But the money from that gain isn’t really in their pockets, it’s actually paper gains – money they do not yet have, but think they have.
This is becoming increasingly popular in bull markets and booms in the economy. One very popular example of this is when investors spend paper profits on various stocks. By paper profits, I mean that, while the stock has moved higher, investors have not sold the stock and are basically betting that the gains they have then will be there when it comes time to pay the bills. Something very similar to this occurs when investors spend money in anticipation of increased gains in a stock or the stock market. These "paper profits" aren’t even on paper (relatively speaking), so the investor is simply gambling.
That being said, if past performance does not predict future results (just see the disclaimers of any mutual fund), how can we spend money we do not actually have? We would be assuming future results will at least match past results. But you know what they say about those who assume...
Am I guilty of doing this?
Sure, but does that make it right?
Not really, believe it or not, I’m not perfect! In fact, I’ll probably still spend paper profits after putting everything in perspective in this article. But my personal foolishness is beside the point.
Let’s put this baby into perspective. Take the latest market correction (or crash). Remember the days when you came home from work (or watched all day) and saw the market move higher everyday? Remember that? Well, investors figured that nothing could kill such a great bull market and bought like crazy. While this does help the bull market continue (higher Consumer Confidence is always nice), eventually it catches up.
Think about it this way... you spend more money because you think you have more money.
But wait, no company bonuses, no salary increases, no lottery winnings, where’s this new money coming from? Trees? We all know money doesn’t grow on trees. To put a theory to rest, if money did grow on trees, we’d have inflation and then that money wouldn’t be worth anything anyway. It's all supply and demand, my reader (remember Econ 101?). But back to my point, where are you getting this money to spend? Ahh, the stock market. "My stocks are up; therefore, I can spend more money," says the typical investor. "Even though I don’t actually have the money, it’s still there, right?" But that is where you are wrong, dear investor. Actually, this is a case of the aforementioned paper profit and, thus, wealth effect.
But where does this new spending power actually come from... if you don’t have money in your pocket, where is it? Why, it’s on plastic, in a little card with your name and a 16 digit number on it! For a while, everything is going great! The market’s up, you’re spending more, everyone can sit back and smile, and then...
BOOM!!!
Reality check!
The market comes back to life. All of a sudden, you can’t pay those credit card statements, that Ferrari doesn’t look so good anymore, and the credit card companies have the last laugh! |
