Don't Fall for the 'Wealth Effect'
We're all rich now... Economics 101... It's not screaming 'imminent crisis'... Low returns happen fast... Is this a bubble or not?... Markets are nutty... Buy quality and don't overpay...
Do you feel rich?
I (Dan Ferris) am not asking if you are rich.
I'm asking if you feel rich.
If the answer is yes... the reason is likely because your home and investment portfolio are worth a large amount.
That's the wealth effect.
Technically speaking, the wealth effect is when folks spend more because their assets have increased in value. But to me, that's just another way of saying folks spend more because they feel richer.
And today, more folks than ever are feeling richer...
The S&P 500 Index has gone up more than 20% in each of the past two years. And households have never had so much of their net worth in stocks. The latest Federal Reserve data shows that households have 43% of their net worth in stocks as of the third quarter of 2024 (the latest data point available). With household net worth just shy of $160 trillion, that's nearly $69 trillion in stocks.
The S&P 500 is up nearly 3% since the end of the third quarter, so households probably have even more than that in stocks now.
The other big component of net worth – home equity – is also hitting record highs. In the second quarter of 2024, household equity in real estate was $35.3 trillion. It fell slightly in the third quarter but is still high at just shy of $35 trillion. That translates to about 22% of households' net worths.
Add stocks to that, and Americans have $104 trillion – roughly two-thirds of their net worth – in stocks and home equity.
And with stocks and house prices rising, many folks feel rich today.
Now, the wealth effect isn't a disaster if you don't go overboard. But if you're spending more than you earn and borrowing the difference, you'll eventually face a day of reckoning when you have to sell assets to pay off debt.
It's Economics 101...
When you save and invest, you forgo current consumption and accumulate wealth.
Spending less than you make is the simplest way I know of to describe what it means to get rich, and having a big pile of money you don't spend is the simplest way to describe what it means to stay rich. Like so many things in life, being rich is just as much about what you don't do (spend) as what you do (save and invest).
Spending some of what you have is okay, as long as you still have plenty left over. But borrowing adds another source of risk to the equation.
Borrowing means you're spending your future earnings today and pulling forward your future demand for goods and services.
Not all borrowing is stupid. It makes sense for a lot of people (but not all) to borrow money at a fixed rate to buy a house. The value of your house will probably track the rate of inflation and might do even better, depending on where you live and other factors.
Plus, having a comfortable place to live can be of great value to you. And let's not forget the mortgage interest deduction, which can lower your taxable income.
So you (usually) get a lot of value for the money you borrow when you buy a home.
It makes less sense to borrow for things you don't really need right now, like jewelry, toys, gadgets, fancy handbags... whatever your particular vice might be. But that's how folks behave when their assets go up in value and they start feeling rich.
The wealth effect is in place today...
Folks feel rich. So they're spending.
Consumer spending is hitting record highs. Personal consumption expenditures reached an all-time high of $20.2 trillion annually as of November, according to the latest Fed data. The data includes things we need, like food, energy, health care, and transportation, but it's a reasonable proxy for overall spending.
And folks are borrowing more, too.
Federal Reserve data on credit cards and other revolving debt plans shows consumer borrowing hit a record high on December 25, just shy of $1.1 trillion.
While spending and borrowing aren't rising relative to GDP, folks are saving less as a percentage of their incomes.
Moody's Analytics Chief Economist Mark Zandi recently published data that divides Americans up into six groups by income. Four of the six groups are currently saving around zero percent. If you delete the effects of the COVID-19 pandemic, which spiked the savings rate to double-digit rates as high as 32%, Americans have an average savings rate of about 5.2% of income since 2015. The most recent monthly reading is lower than that at 4.4%.
In short, folks are feeling flush enough to tap into their savings, or at least save less and spend more of their paychecks. They're not really thinking about a day of reckoning when they'll have to cut spending and worry about paying off high-interest consumer debt.
Now, the situation doesn't scream 'imminent crisis'...
But in a post on the social platform X, Zandi warned about how this could play out...
The economy is highly vulnerable to a sell-off in the stock market. Growth is being powered by consumer spending, and more specifically by the spending of the very well-to-do. The soaring stock market has made these households much wealthier and thus able and willing to lower their saving rate and spend more out of their income. Since they do the bulk of the saving, if they save less, it adds up to a lot of spending. But if the stock market falters, something I've argued is a serious risk, these wealthy households would surely react by saving much more and spending less. This would quickly become a threat to the overall economy.
In other words, Zandi is warning that a falling stock market could lead to economic decline due to a reversal of the wealth effect. Many folks who feel wealthy right now are vulnerable to a sudden reversal of fortunes.
He has a point. Those spending more and saving less based on the wealth effect are looking in the rearview mirror. They see that the market has gone up more than 20% in each of the past two years, and they're confident that more gains will follow.
But rationally, we should temper our expectations for returns from current levels for at least a few years. I'm not saying (now or ever) that you should sell all your stocks because the market is pricey. I'm saying that returns are the inverse of valuations. High valuations lead to low returns, and low valuations lead to higher returns.
The prospect of lower returns for a few years doesn't sound like much to worry about...
Negative returns present a more troubling prospect. The folks at asset-management firm GMO recently published their seven-year asset-return forecast as of November 30. According to them, U.S. large-cap stocks are priced to earn negative 6.3% over the next seven years, and U.S. small caps are price to earn negative 5.3% during that period.
As author and investor Howard Marks pointed out in his latest memo titled "On Bubble Watch"...
You might say, "making plus-or-minus-2% wouldn't be the worst thing in the world," and that's certainly true if stocks were to sit still for the next ten years as the companies' earnings rose, bringing the multiples back to earth. But another possibility is that the multiple correction is compressed into a year or two, implying a big decline in stock prices such as we saw in 1973-74 and 2000-02. The result in that case wouldn't be benign.
Simply put, lower or negative returns likely won't arrive in an orderly manner that makes them easier to tolerate. When markets are super expensive (like right now), they don't get cheaper gradually and painlessly. Just as they went higher for longer than anybody could have predicted, they tend to get cheaper much faster and more painfully than anyone would ever have believed. Bubbles and their eventual bursting tend to astound everyone involved – even those like me who repeatedly warned that something bad would happen.
When you're down 50% after a year or more, it can feel like there's no end in sight. That's when many people sell out in a panic near the bottom. That's how markets bottom: by wiping out those who can't take the pain anymore.
So the higher valuations go, the more careful you should be. As we pointed out last week, folks tend to make up a bunch of reasons why stocks will keep going up. Marks captured the mindset well...
So, to discern a bubble, you can look at valuation parameters, but I've long believed a psychological diagnosis is more effective. Whenever I hear "there's no price too high" or one of its variants – a more disciplined investor might say, "of course there's a price that's too high, but we're not there yet" – I consider it a sure sign that a bubble is brewing.
Everybody thinks, "We're not there yet," until long past the top of a frothy, expensive bubble market. The truth is, nobody knows we're at the top until it's over.
Now, Marks did offer the following counterarguments to the idea that the market is in a bubble right now:
- The [price-to-earnings (P/E)] ratio on the S&P 500 is high but not insane,
- the Magnificent Seven are incredible companies, so their high P/E ratios could be warranted,
- I don't hear people saying, "there's no price too high;" and
- the markets, while high-priced and perhaps frothy, don't seem nutty to me.
Marks also stresses that he's not a technology expert or equity analyst, so he "can't speak authoritatively about whether we're in a bubble."
I'm also not a tech expert, but I am an equity analyst...
And I think we're in a bubble.
For starters, the cyclically adjusted price-to-earnings ("CAPE") ratio is at 37.6 – one of its highest levels since 1871, a clear sign we're in a massive bubble.
As we said in our November 15 Digest, the top 10 S&P 500 stocks (including the Magnificent Seven) also recently traded at 50 times earnings (42 if you take out egregiously expensive Tesla). That's exorbitant enough to cause concern.
As for Marks' last two points... I don't care what people say about how much they're paying. I care about how much they're actually paying. And they're paying the highest valuations in history by some measures.
Meanwhile, markets are nutty. People are buying MicroStrategy (MSTR) at twice the value of its bitcoin holdings and a worthless Fartcoin cryptocurrency has an $800 million-plus market cap.
In short, I think we're living through a massive multiyear top of the biggest mega-bubble in recorded history. It started topping in 2020, when interest rates scraped 5,000-year lows. It's still topping out today, with the S&P 500 CAPE ratio at one of its highest levels going back to 1871.
I won't predict when the S&P 500 will ultimately peak. I won't predict how long it'll take for the subsequent bear market to play out. But history suggests that it's reasonable to expect U.S. stocks to lose 50% or more of their value from the bull market peak to the bear market trough. The S&P 500 fell 49% during the dot-com bust... and 56% during the great financial crisis.
But it's not all bad news...
If you had invested in high-quality businesses through both of those bear markets, you would have made a lot of money by now. All you needed to do was avoid the garbage that folks were most excited about.
In 2000, that was dot-com stocks. In 2009, it was banks and mortgage-related investments. And if you avoided money-losing tech garbage, clean energy, and cannabis stocks in 2022, your 401(k) is probably looking pretty good these days.
Today, avoid speculations like MicroStrategy and its leveraged bitcoin-buying scheme and meme coins like Fartcoin. Instead, focus on profitable, high-quality companies that can give you good returns – even during a bear market. If a bear market starts this year, it likely won't last more than two or three years.
Now, we could also wind up in a Japan-like situation where markets go sideways for three and a half decades. I've occasionally warned that current conditions suggest this scenario is more likely than most folks imagine.
Still, if you stick to quality and shift your focus to value-priced stocks once the bear market has pulled stocks down 40% or 50%, you should continue to earn good returns – even if the market goes sideways for several years.
In other words, it's not about whether you're in the stock market... It's about the quality of the stocks you own and how much you paid for them.
If you pay bubble valuations, even the highest-quality companies can produce lousy returns. But if you're careful and don't overpay, your portfolio can perform much better than average, even if a bear market ensues.
No new 52-week highs to report from yesterday, as the U.S. stock exchanges were closed for a national day of mourning for former President Jimmy Carter.
In today's mailbag, feedback on yesterday's edition, which included talk about Elon Musk lowering the expectations for what the Department of Government Efficiency ("DOGE") might do... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Regarding Musk's goal to reduce federal government spending, does anyone remember the Grace Commission? It was an investigation requested by Ronald Reagan in 1982. The report said that one-third of all income taxes are consumed by waste and inefficiency in the federal government, and another one-third escapes collection owing to the underground economy. The report claimed that if its recommendations were followed, $424 billion could be saved in three years, rising to $1.9 trillion per year by the year 2000... Maybe [DOGE] should buy a copy of the report to start with!" – Subscriber Dave O.
Good investing,
Dan Ferris
Medford, Oregon
January 10, 2025