The Diminishing 'Wealth Effect' and Your ETFs

NEW YORK (ETF Expert) -- In previous years, consumers spent more money when the value of their 401(k)s and the value of their homes were rising. That goes a long way toward explaining the performance of the third best sub-sector ETF on a rolling five-year basis.

Specifically, SPDR S&P Retail (XRT) annualized at 16.1% over the past five years while the S&P 500 SPDR Trust (SPY) only annualized at 4% between Feb. 1, 2008 and Jan. 31, 2013.

The idea that we tend to spend more when our chief assets are climbing is known as the "wealth effect." There was a time when leading economists estimated that we were likely to spend 3 cents for every $1 gain in stock portfolios as well as 8 cents on every $1 gain of home price appreciation.

The chairman of the U.S. Federal Reserve, Ben Bernanke, still believes in those metrics... at least conceptually. He recently told Congress the Fed's quantitative easing efforts to depress interest rates lead to economic growth via consumer spending as well as business hiring. Even a number of investors must believe in the notion of increased consumer spending, or they wouldn't have bid up the prices on XRT over the last five years.

5 Best Performing Sub-Sector ETFs (2/1/2008-1/31/2013)
						5 Yr % Annualized
PowerShares DJ Pharmaceuticals (PJP)						17.4%
First Trust NYSE Arca Biotech (FBT)						16.6%
SPDR S&P Retail (XRT)						16.1%
First Trust DJ Internet (FDN)						13.4%
iShares FTSE NAREIT Residential Real Estate (REZ)						9.0%
S&P 500 SPDR Trust (SPY)						4.0%

On the other hand, what if the "wealth effect" offers diminishing returns? The U.S. government (through tax relief) and the Fed (through drastic rate cuts) were remarkably stimulative in the wake of the 2000 tech bubble and the Sept. 11, 2001, attack. Consumers did begin spending and businesses did begin hiring at a modest pace.

In the aftermath of the 2008 real-estate related collapse, the U.S. government added tax relief and billions in government spending, while the Fed reduced rates to 0% and employed electronic money printing to buy U.S. Treasuries.

Consumers have begun spending again, but not in the same manner they did after the 2000-2002 period. Businesses did begin hiring, but nowhere near the levels of job creation after the 2000-2002 period.

If the stimulus measures after the 2007-2009 financial catastrophe have not been as effective at getting businesses to hire or the economy to grow, what does that say about the current state of affairs?

If Congress now chooses to stimulate by refusing to make meaningful deficit cuts and the Fed intends to stimulate by staying the course on its present manipulation of interest rates, will this "de facto" stimulus be enough to enhance the economy significantly? Conversely, is 2% GDP with labor force participation rates near 30-year lows the best we should expect?

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