Link: The Wealth Effect, Your Portfolio, and Your Retirement

The net worth of Americans is declining. That is no secret, though the extent of the decline will surprise many. The decline has affected and will continue to affect the economy, stock market, and your portfolio. The Federal Reserve gives a picture of the net worth of Americans every quarter, in a report known as the flow of funds data, and it is worth periodically studying the report.

The report for the third quarter of 2008 (which does not include the steep declines of October and November) was an eye-opener. It also does not include the losses from the Bernie Madoff scam and other frauds that have come to light, though they are a small percentage of the total.

Here is the real eye-opener in the report. In the third quarter Americans were so alarmed by the decline in asset values that they actually reduced their debts. This has not occurred since the data were first reported in 1952. In the third quarter, household borrowing, mortgages, and consumer credit fell at a $117.4 billion annual rate. Granted, that is a drop in the bucket compared to the asset values and amount of debt outstanding. But it does show a significant change in Americans’ behavior and thinking.

Part of the decline in debt can be explained by defaults shrinking the amount of debt outstanding and by tighter lending standards reducing the amount of new debt. But part of the decline was due to consumer decisions.

…Shrinking home equity means people cannot borrow against it to increase spending. Paying down debt means there is less spending than income will support. The declines in net worth and debt overshadow by a large amount the recent decline in gasoline prices that many expect to increase consumer spending.

The influence net worth has on spending and borrowing is known as the wealth effect, and it is important to understand.

Many people believe that Americans spend based on their incomes, but a more important determinant of spending is net worth, or perceptions of net worth. As people perceive themselves to be wealthier, they spend more. An increase in asset values stimulates additional spending above income increases. People will spend more than their income if they believe their net worth is increasing. Some analysts estimated that in the boom years Americans were spending about $1 trillion more annually than was supported by income increases.

Link: The Wealth Effect, Your Portfolio, and Your Retirement

In the third quarter of 2008 consumers finally realized the declines in asset prices were both serious and not likely to be temporary. They reduced debt and increased savings. They will continue to increase savings to make up for these asset declines until asset prices increase.

The wealth effect is another of the ways this economic cycle is different from those of the last 26 years. I believe many consumers will not ignore the recent declines in their homes and portfolios. They won’t keep spending in the belief that the net worth decline is short term. Instead, I think we will see changes in consumer saving and spending that will last for at least a few years. This will reduce economic growth below what most models forecast and make it harder for the economy to rebound. It also will be very tough on retailers, luxury goods and services sellers, and others who benefit from high consumer spending.

Because of the wealth effect, we should not expect a sharp recovery in either the economy or equity markets. It also makes it likely that even after the economy reaches a bottom, economic growth and stock returns will be lower than the averages. That means you will want a different portfolio than the one that worked before the markets peaked.