The Poverty Effect? - TheStreet

Have you considered the chance that the so-called wealth effect could work in reverse? Given the weakness in stocks this month, and again today, you might want to.

The effect -- a virtuous cycle of rising stock prices buoying the economy, and therefore the market -- has paused for the first time in years. If stocks continue down, the decline may slow consumer buying, companies' capital expenditures and

GDP growth. That, to put it mildly, would not be a plus for stock prices.

Economists have taken to thinking about the effect of equity prices on the real economy fairly recently. Investors began to pay attention to the linkage in recent years after it became clear that

Fed Chairman

Alan Greenspan used it as a measure of financial and monetary conditions that he considered when setting interest-rate policy. Now, we all do.

There is a lot we don't know about the wealth effect. Economists can only estimate its macroeconomic effects. The folks in economic research at

Goldman Sachs

guess for every $1 decline in total stock-market capitalization, consumption drops 2 cents to 3 cents. Other economists go as high as 7 cents per dollar. And what about the impact of changing stock prices on investment? Analysts at the research boutique

International Strategy & Investment

say that capital expenditures, which have helped drive the remarkable economic growth in this economic cycle, are definitely bolstered by a rising stock market. But who can say by how much?

Then there's the question of how long it takes for consumers and companies to shift their buying and investing habits in response to fluctuations in stocks. Goldman economist Jan Hatzius tells me, "There is generally a pretty long lag. The maximum effect of changes in equity prices occurs after four to five quarters. People take a while to adjust their consumption patterns. They don't realize the gains of losses immediately."

Declines Sting More Than Gains Soothe

Hatzius adds, however, that a decline in the stock market might feed into the real economy sooner than a rise would. Why? Simply because researchers have found consumer confidence to be more sensitive to declines in stocks than to rallies.

Slight changes in consumer spending and investment can, of course, make big differences to GDP growth. They have a multiplier effect on the overall economy. Hatzius estimates that a 10% decline in the market from current levels would trim 1 to 1.5 percentage points off growth. How hard would that hit corporate profits? He will only say that earnings typically decline far more than revenues in a slowdown.

So how much credence should we give the notion that a weak market would weaken the economy , which in turn would cause the market to slide lower still? ISI's Jason Trennert thinks we should take the idea quite seriously.

"I think we would wholeheartedly agree with that idea," says Trennert. "We use the

Wilshire 5000

as the measure of the market, and we see a strong correlation between moves in the market and moves in consumer spending. It's pretty clear that both the

S&P 500 and the

Dow have been flat for over a year. That is not something that has been true before. That implies consumer spending will be more sluggish than expected."

A Slowdown That Could Surprise

He cites already slowing consumer spending as a sign of a reverse wealth effect unfolding right now. Combine that with higher oil prices, which also drag down consumer spending, and with higher interest rates, and you have a recipe for a slowdown that might surprise people. ISI is not calling for a recession, but it pegs the odds of a recession at 30%.

A reverse wealth effect -- let's call it the "poverty effect" -- might play out this way. Say stocks continue to trend lower on earnings disappointments, a larger than expected oil price shock, whatever. The market's slide leads frustrated investors to trim back their spending. Earnings growth slows as well. Companies whose fates are tied to the consumer -- and that includes a fair number of tech companies -- cut capital spending. Job creation slows.

ISI sees signs that the poverty effect is already in motion. Based on the firm's proprietary survey of companies, not only are auto, chemical, manufacturing and retail companies seeing a slowdown, but so are technology companies. ISI's survey of nine large and diversified

Fortune

500 technology companies was completed last week. According to ISI, the tech sector "declined this week and fell to its weakest level since March. The decline was primarily due to slower revenue growth from PC manufacturers in our survey. While our contacts in this space have highlighted slower consumer demand for the past several weeks, there was some sense this week that enterprise

i.e., corporate spending was slowing as well."

What might happen next to the market and the economy depends on a bunch of imponderables. Where are oil prices? How quickly might the Fed cut short-term interest rates? Would the inflation hawks at the Fed lower rates if oil prices remain high into mid-2001? How will the dollar hold up if all those Europeans start losing money on their U.S. investments? Might they want to repatriate some of their capital? If they do, will the Fed hold rates steady, or even raise them, to stem the flow out of the dollar?

Keep an eye on warning signs of the poverty effect. So far we have yet to see any drop in consumer confidence. If we do, pay attention. That would be a sign that the weak stock market is bothering people. Rises in initial unemployment claims, which are reported weekly, are also worth watching. If you see sudden moves in these measures, you can reasonably expect trouble ahead for stocks.