Consumers Don't Seem to Care

About Small Market Corrections

A 10 percent correction in the stock market used to be a big deal. Now it can happen in less than a week.

While all news all the time "24/7" as the customer-service folks like to say keeps investors well informed on every intraday wiggle and wobble in their equity portfolio, some of the corrections and sector rotations are so quick that if you take a long nap, you may miss the whole thing.

Recently, for example, the Nasdaq Composite Index shed 9.2 percent in a three-day period. At the same time, the Dow Jones Industrial Average, which had been in a two-month slump, produced its biggest two-day rally (8.4 percent) since the aftermath of the 1987 stock market crash.

If consumer confidence is closely tied to stock market performance, and consumer spending is a reflection of how people feel about their present and future states, then it's going to take more than a quick one-two dousing in the stock market to dent consumer spending.

"It would probably take a 15-20 percent correction, with stock prices staying down, to have an impact on consumer spending," says Cynthia Latta, principal U.S. economist at Standard & Poor's DRI, which maintains a macro-econometric model. "If stocks just show signs of coming back they don't actually have to come back all the way it won't have a lot of impact."

'Unblemished optimism'

Consumers don't think oil prices will stay high, Latta says (neither does the oil futures market). "They have unblemished optimism about the future. They have jobs and income. It will take a big correction to get them to retrench."

The wealth effect operates with a lag. Or, as Latta puts it, what's important is the accumulated wealth.

"Even if the stock market held steady for the entire year, the conventional wisdom suggests that there is still stimulus in the pipeline," says Jim Glassman, senior economist at Chase Securities. "The models suggest that we'd get a half-point added boost to consumer spending in 2000, and in 2001 the effect would be neutral, not negative."

That means if the Wilshire 5000, which bears the closest resemblance to household wealth because it includes 92 percent of U.S. market capitalization, were to go sideways for the rest of this year, consumers would still feel and act wealthy.

The Wilshire 5000, which, contrary to its name, contains over 7,000 capitalization-weighted securities, is up 2.6 percent year to date, following annual gains of 33.4 percent, 18.4 percent, 29.2 percent, 21.7 percent and 22 percent, respectively, from 1995 to 1999.

Will the small advance in the Wilshire be enough to stay the hand of Federal Reserve Board Chairman Alan Greenspan, who claims the wealth effect is fueling excess demand relative to supply?

The Fed raised the federal funds rate by 25 basis points to 6 percent last week and issued a statement saying the risks to the economy are weighted toward higher inflation. Both the stock and bond markets shrugged off the as-expected outcome of the policy meeting.

If investors were looking for some clarification on just what the Fed is targeting Greenspan says the wealth effect must be contained, but denies he's targeting stock prices none was forthcoming. (Don't look for the Fed to vary its four-paragraph format to convey policy changes and balance of risks anytime soon.)

Certainly the chairman owes us an explanation as to why productivity growth, which increases the economy's potential supply, is now contributing to excess demand and inflationary imbalances. Not to mention the fact that the concept of "excess demand" is of questionable authenticity, according to some economists.

Defining demand

"There is no such thing as demand," says an economist who requested anonymity. "It has no meaning. There is only a demand schedule: an equation, or a table, relating price to the quantity demanded."

Excess demand, as the chairman calls it, can push prices up. If it's the price of a broad basket of goods and services, then it's known as inflation, which is the product of too much money creation by the central bank. But demand can't exceed supply because we can only buy what we produce.

"The amount of goods produced will find demand at some price," he says. "That's the price at which the market clears."

If Mr. Greenspan was on tenuous ground railing against the shrinking pool of available workers, and if he was on thin ice talking about productivity creating inflationary imbalances, then he is truly drifting out to sea on an ice floe with the concept of excess demand.

Caroline Baum is a columnist with Bloomberg News.

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