The 'wealth effect' holds up market

Is the market heading south?

Probably not. There are lots of reasons the market could sell off, however, the market is as subject to human emotions as anything in economics. Right now, the market remains strong because of great investor confidence.

The market is near its all-time high; business conditions are better than they have been in years; companies, individuals and banks are holding more cash than at any time in history, and the country’s “wealth effect” has exploded.

What does the “wealth effect” mean?
The Federal Reserve’s “wealth effect” theory assumes that a large increase in real estate and stock market values will inspire consumer spending, which represents 65% of gross domestic product.

Recently, U.S. national wealth reached a record high of $81.5 trillion. (See chart.)

The Dow is selling at almost 20 times earnings. Explain why the stock market is not in another bubble.
Consumer confidence is shown in price earnings multiples. In this market, investors are willing to pay nearly 20 times earnings for a stock, considerably more than the 14.2 times average over the years. Good things are happening in our economy. The U.S. is becoming one of the world’s low-cost manufacturers again because productivity gains have been so great in the last several years. Former low-cost producers, such as China, are suffering tremendous increases in costs, making them much less competitive than they were 10 years ago. U.S. unfilled manufacturing orders are at a record high, and problems in other economies have forced wary investors to put money into U.S. opportunities. Also importantly is that borrowing costs remain low.

Are other economies in trouble?
They are not so much in trouble as they are over leveraged. At this time, the U.S. economy is producing much more cash flow to cover debt than the rest of the world’s economies are producing.

The government is talking about reducing quantitative easing sometime next year. Is that true, and will that help the market?
It’s probably not true. Quantitative easing is a disguised name for creating or manufacturing money. Citizens do not understand that quantitative easing is strictly to pay for the government’s deficit spending. The only reason quantitative easing has gone down from $1.2 trillion a year to $450 billion is that income in the economy has increased. Tax revenues, therefore, are at a record high. Government expenditures have not been reduced at all. Increased tax revenues from an improved economy are the reason government money making has been reduced, not because the government has gotten expenditures under control.

How can the market continue to remain at these levels if government expenditures are not under control and there is no plan to get them under control?
Investor confidence. As soon as investor confidence wanes, the market will deteriorate in value. Causes of reduced investor confidence are debt, war, high interest rates, declining employment, a tight loan market and cash shortages. None of these events is now occurring.

Political influence
The market is simply not predictable. It is also subject to political influence. The political balance in this country has become dictated by three groups: those who receive government welfare checks; taxpayers who subsist without help from the government; and government employees.

There are 22.5 million more U.S. citizens who work for the government or are on welfare than there are individuals working in the free enterprise system, which supports everything. Welfare recipients are unlikely to vote for a candidate who is going to cut back welfare. Government employees would vote likewise because a significant percentage of their jobs are devoted to serving the welfare class. Workers, taxpayers and nondependent government citizens are the minority, and they support this country’s economy. They are additionally the ones who own stocks, real estate, bonds and other taxable assets. So, this latter group that is involved in the stock market and management of the nation’s assets must realize there can be no overnight change in the voting balance.

Summary
It is odd that despite the creation of more wealth in a shorter period of time than any time in history, nobody seems to notice. Household wealth is up 18.5% over 2006’s record, even after a disastrous downturn from the recession. For the bloated stock market, one would expect much more excitement. The public seems bored with the richest market in history.

As long as cash flow is increasing, the market should continue to hold its own, and perhaps, increase.

Investor confidence is unlikely to be undermined until excessive government expenditures and interference provide enough anxiety that the cycle of positive investor confidence turns negative.

When values are high, we need to be especially wise in picking stocks. Fewer good values are available.

There is nothing wrong with holding cash while waiting for the right values. Patient investors are rewarded with higher returns.

Caveat emptor.

Value of U.S. household wealth
2006 - $68.8 trillion

2009 - $55.6 trillion

2014 - $81.5 trillion

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.