The US stock market is entering a correction mode. There is a lot of speculation about whether this is a short-term buying opportunity or a longer term meltdown that will wipe out years of gains. Ideally, investors should use fundamental analysis of intrinsic stock value and technical analysis trading signals as guides, to buying and selling stocks, bonds, real estate and other investment vehicles. But, human nature being what it is, we invest more aggressively when the market goes up and pull back faster when the market goes down. A part of what is going on today is a reverse wealth effect. Here are some thoughts about this phenomenon and how the reverse wealth effect will change your investing and your investments.

The (Reverse) Wealth Effect

Investopedia defines and explains the wealth effect.

The wealth effect is a theory suggesting that when the value of equity portfolios are on the rise because of accelerating stock prices, individuals feel more comfortable and confident about their wealth, which will cause them to spend more. In 1968, for instance, economists were mystified when a 10 percent tax hike failed to put the brakes on consumer spending. Later, the sustained spending was credited to the wealth effect. Even though disposable income declined because of the additional tax burden, wealth continued to grow because the stock market persistently climbed higher.

The wealth effect was especially pronounced in the years leading up to the financial crisis and Great Recession. Low interest rates encouraged people to buy more expensive homes than they could otherwise afford because mortgage payments were so low. Many purchased second and third homes, using equity taken out of their primary residence, because they were now “so well off.” This wealth effect also drove up stock prices past when fundamentals and technical indicators would support.

When this effect has gone on for a while, smart investors start to sell and take profits. Prices go down, and we have a reverse wealth effect. In a Forbes articles entitled, 4 Reasons to Sell Your Stocks Today, the author says the reverse wealth effect will drive stock and real estate prices down, and is already doing so.

Economic statistics reveal a critical connection between stocks, real estate and human psychology. When stock prices rise, those who own them feel confident in bidding up the price of real estate. What’s more, when interest rates are low, they don’t mind borrowing lots of money to buy the houses. Conversely, when stocks fall, it does not take long for people to suffer from a reverse wealth effect.

This effect is multiplicative. When stock prices go down, folks who feel less wealthy tend to panic and sell in order to preserve some of their wealth. The falling markets in stocks and real estate drive others to feel the reverse wealth effect and the downward price movements accelerate.

And, the reverse wealth effect reduced people’s spending by about cents for every dollar reduction in personal wealth. So, not only will stock and real estate prices go down but spending will reduce across the board which will slow the economy, further adding to the declines in property values and stock prices.

How Bad Could This Get?

According to Investopedia, Morgan Stanley says the worst is yet to come.

“Not only does the price action this year suggest we are in the midst of a bear market-more than 40% of the stocks in the S&P 500 are down at least 20% – but it also trades like a bear market,” wrote the bank’s analysts. Even companies with good news to report have seen their stocks sell off, a good indicator that the market is in bear territory. Overall, says Morgan Stanley, “The technical damage is irrefutable.”

It is our opinion that as investors feel less and less wealthy, they will sell and take the markets down for a protracted bear market both in stocks and real estate. The losses will probably not wipe out all of the gains of the last years, but may still be substantial.

What Should You Do?

The answer to dealing with a market correction has to do with your investment horizon. If you were looking for short term gains, this is probably a good time to take them. If you are in for the long term, consider adjusting your portfolio, looking for investments that do not lose money, and wait for the bottom of the market to pick up bargains.



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