If you look at the financial landscape these days, and try to understand why things are the way they are, it is very important to understand a thing called “the wealth effect.”
Essentially, the wealth effect is the effect feeling wealthy has on the population – whether they be strictly consumers, equity investors or both. At the very bottom of the economic spectrum, there are people at the poverty level, who, out of necessity, spend every dollar they make.
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This is one justification for welfare programs – you are basically doing something noble – keeping someone from starving to death and essentially guaranteeing that the money you give to people in this situation goes right back into the economy. However, the wealth effect has to do with people higher up on the economic ladder – those who spend and invest discretionary income – income that they do not need to provide for their basic needs.
Imagine that you have an investor with $10,000 in a stock portfolio. If that original investment depreciates to $8000, all things equal, the person will feel more cautious and generally less willing to spend or invest. On the other hand, if that same investor sees his portfolio rise to $12,000, he will feel more willing to spend either take his profits and pay taxes or increase the amount invested or risk taken.
If the investor takes his profits and spends these gains, it has a positive effect on the economy. So all things being equal, when investors are making money, they are spending money and it is a very positive, virtuous cycle. In the big picture, that is why the Federal Reserve’s Quantitative Easing exists. It stimulates asset prices and causes them to rise.
This is one of the reasons why I am so bullish on the stock market – notice I did not say the economy, let alone the issue of whether any of this is the “right” thing to do. QE is boosting the prices of assets such as real estate and stocks, so that investors have gains and feel wealthy, which will lead them to take more risks, invest more and in the end spend more money.
So due to QE, we are in what I like to call an asset driven economy as opposed to an economy led by business activity.
Ultimately, as an investor, I am trying to figure out whether, if I buy something today it will be worth more in the future. As the market hits new highs in the S&P 500 Index (SPX) and Dow Jones Industrial Average (DJIA), it removes more worry from the markets.
I have no way of knowing for sure, but I believe that the last new high that has not been taken out – the Nasdaq (NDX) high of just over 5000 – will be the next one to be reached. Whether it is justified by fundamentals or not, there are still people who are losing money in stocks that bought in 2000 – over 12 years ago.
Needless to say, these people don’t feel particularly “bullish” or optimistic about the stock market. So I believe that although it is nothing that the Fed would actually say, QE will not end until all of the indexes are at new highs.
All this explains why I am overweight large cap tech – the stocks that drive the Nasdaq. Of course, the other indexes will be pulled higher as well, but the cyclically sensitive tech sector is my best guess on where the value is in this market right now.
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