- by New Deal democrat
I rarely comment on the financial markets directly, since my focus in on the economy and how it impacts ordinary working and middle class Americans, especially in the near future. But in some cases, the financial markets themselves play an important role in that picture. And this is one of those times.
Specifically, in terms of what is called the “wealth effect.” It means that when people’s wealth increases, even if it only on paper, they tend to spend some of that gain. According to Ned Davis research, it averages about 40% of the amount of the gain.
Well, since the post-“Liberation Day” April bottom, the stock market as measured by the S&P 500 has increased almost 35%. Meaning, for example, that a household that held $100,000 in that index in April has seen it grow by $35,000. A wealthier household that held $1 million, has gained $350,000. And so on.
As I have pointed out a number of times in the past several months, it is strong consumer spending that is keeping the economy going forward, despite recessionary signs elsewhere.
But how robust, or fragile, are those gains? One of the best historical measures I have found to be the “advance-decline line.” This subtracts the number of stocks which have lost value on any given day from the number which have gained. For example, if there are 1000 stocks in a bucket, and 550 have advanced and 450 declined, then the advance-decline line increases by 100. If the advance-decline line shows that the broad mass of stocks are participating in an advance, that is a good sign, because it suggests that many sectors are benefitting. But if it is narrow, or worse even declining, while the market index increases, that means that only a few stocks in a narrow sector or group of sectors are participating, suggesting trouble for the markets, and the economy, ahead.
There are two very good examples of the advance-decline line giving such a signal.
First, here is the late 2006-2007 time frame just before the onset of the Great Recession. The top graphic is the NYSE, the second is the advance-decline line for the S&P, and the bottom is for the S&P 500:
Note that even as stocks broke out to new highs at mid year, and again to their early autumn peak, the advance-decline line retreated in spring, and was even lower by autumn. This told us that the economy was resting on a narrow slice of sectors.
An even more breathtaking example is that of the Dotcom bubble of 1999-2000:
Here the advance-decline lines for the NYSE and S&P 500 declined sharply throughout the latter part of 1999 into 2000, even as the index raced ahead by almost 50%! This was a telltale sign, indicating that outside of the bubble economic prospects were not good at all.
So how has the advance-decline line been behaving this year? Here’s the answer for the S&P 500:
As indicated above, since the bottom in early April, stocks have increased by almost 35%. The advance-decline line participated fully in the springtime advance to mid-year.
But since early July, while the S&P 500 has increased almost another 10%, although it has not declined the advance-decline line has only increased by about 1%.
This is “yellow flag” territory. Slightly more stocks than not have been participating in the advance. But compared with the amount of the advance, it is quite narrow.
I would need the advance-decline line to actually turn down before it would signal a “red flag” for me.
But here is the important thing to keep in mind. If the AI-focused stock market is in a bubble - which is almost impossible to know while you are experiencing it - then whenever it pops, stock valuations are likely to plunge all the way back to their pre-bubble levels (and maybe overcompensate to the downside).
Which in turn brings us to the opposite of the “wealth effect.” Psychologists have estimated that this “negative” wealth effect is about twice as potent as the “positive” one. In layperson’s terms, people *really* hate to lose money. When that happens, they pull in their horns much more dramatically than when they spend some of their paper gains.
The conclusion here is that it doesn’t look like the turn is imminent. But if and when the turn comes, if other economic circumstances are close to what they are now, the contraction could be rather sudden and intense.
