Can We Bear To Keep Buying?

How rich do you feel? That’s the boom-or-bust question for the U.S. economy as Wall Street stumbles through a summer of pratfalls. The great bull market of the 1990s has pumped $9 trillion into investment portfolios and encouraged Americans to spend some of their gains–a trend that has helped sustain prosperity. But the “wealth effect”–the term economists use for the urge to splurge when we feel rich but to pull back when we feel poorer–could pound the economy if we see more days like last Tuesday, when the Dow Jones industrial average dropped 299 points. It was the Dow’s third-largest single-day fall, though in percentage terms it was not among the 100 biggest drops. “People feel they’ve got so much money [in stocks] that they can go out and buy that new house or car,” says Gary Belsky, author of a forthcoming book on the psychology of investing. But in a market collapse, “those items would be the first to go.”

Just ask Robert McGuire, a Mercedes salesman in Raleigh, N.C., who was ruefully watching as the market plunged last Tuesday. “Our customers are very investment driven,” McGuire says. Just last month a retired engineer plunked down $50,000 in cash for a mid-size Mercedes as a present for his wife–a purchase paid for with money made in the stock market the previous week.

Never before have stocks been so important a form of wealth for so many Americans, whether they hold shares directly or through mutual funds and 401(k) accounts. Forty-three percent of adult Americans hold stocks, the broadest ownership ever. And Chris Varvares, president of the forecasting firm Macroeconomic Advisers, traces more than one-third of the growth of consumer spending last year directly to the wealth effect. Economists calculate that investors tend to spend about 4 [cents] of every dollar they gain in stock-market wealth.

All in all, the market boom has become a crucial source of economic well-being. That helps explain why consumer confidence has soared throughout the ’90s even though the average paycheck rose barely until recently. “People who are retired have seen their assets double,” says Jon McGeath, who manages the A.G. Edwards & Sons brokerage office in Oakland, Calif. “They’ve made more money than they ever did working, and it feels terrific.”

Last week’s turmoil on Wall Street was the latest in a summer-long slide that has knocked almost 740 points, or nearly 8%, off the Dow index since July 17, a decline that economists call a correction. (A 20% drop signals a “bear market.”) But a deeper and quieter sort of stock decline has been under way much longer, particularly among smaller companies. For example, the Russell 2000 Index of small-capitalization stocks has fallen nearly 5% since January. Investors have been seeing these declines for some months in their brokerage statements. So as they survey the carnage, a question naturally arises: What impact could last week’s downturn have on my job, my family and the price of the things I buy?

Short answer: Not much if the market doesn’t fall much farther, because the robust U.S. economy remains as sound as it has ever been. While few economists expect a replay of the phenomenal 5.5% growth of this year’s first quarter, most foresee a healthy 2% to 3% expansion rate for the rest of the year. The employment picture also looks bright. The Labor Department reported last week that the jobless rate held steady at 4.5% in July despite a strike at General Motors that forced factory shutdowns. And even with the summer swoon, the Dow closed last week at 8,598, up almost 9% for the year.

But no forecast can measure the volcanic threat created by the crisis in Asia. Economists generally blame the drop in stocks on slumping U.S. exports to the stricken region. The decline limited the growth of U.S. corporate earnings–a key determinant of stock prices–with industries from chemicals to aerospace reporting lower profits in the second quarter than in the same period a year ago. “Asia is unpredictable,” says Allen Sinai, chief global economist for Primark Decision Economics. “I can’t guarantee that there will be no recession in the U.S. next year because no one can be sure about Asia.” Observes David Wyss, chief economist for Standard & Poor’s DRI: “Asia scares us.”

American shoppers, whose spending represents two-thirds of the U.S. economy, hold the key to what happens next. And data released last week were encouraging on that score. Most major retailers said sales surged in July, for the seventh straight gain this year. “Our customers are happy to pay $3,000 for a Chanel suit or $800 for a Prada bag,” says Nancy Husted, a spokeswoman for Denver’s Neiman Marcus store. In Washington the Federal Reserve found vigorous spending across the country on items from housing to air travel. Barbara Szosz, a North Carolina travel agent, reports that her clients are traveling more, and more expensively, with trips to Europe, Australia and New Zealand increasingly popular.

At the same time, Americans’ real wages (after inflation) have finally started to move up after three decades of declines or stagnation, as labor shortages force employers to pay premiums to hire and retain workers. “Wealth is the icing on the cake, but it’s wages that bake the cake,” says Diane Swonk, deputy chief economist at the bank First Chicago NBD. These gradual earnings gains might signal an increase in inflation, because compensation makes up the bulk of most employers’ expenses. But the glory of the economy today is its remarkable balance. While labor costs are indeed rising, they are largely offset by the growing productivity of American workers, who are among the most efficient in the world. And although the strong dollar curbs U.S. exports, particularly to Asia, it also drives down the prices of imports, from clothing to cars and cameras, and thereby keeps inflation under control.

The last line of defense for the U.S. economy is the Federal Reserve, which has the power to cut interest rates if the expansion falters. But Fed Chairman Alan Greenspan, who warned of “irrational exuberance” in stock prices as far back as December 1996, remains more concerned about the threat of inflation than about the danger of a recession or a market collapse. Just last month Greenspan warned that plunging exports to Asia had done little to ease a growing U.S. labor shortage.

But that was before last week’s drop in the stock market, which fostered a sense that slower growth lies ahead. And the wealth effect could greatly worsen matters if stocks really hit the skids. “We’ve got a market that’s doubled in the last three years,” says Stephen Roach, chief economist at Morgan Stanley Dean Witter. “If you lose 10% or 20% after doubling, that’s not real pain. But if you take this correction into the 25% range, the market could hurt more going down than it helped going up.” That’s because people often feel worse about their losses than good about their gains.

Few experts expect stocks to take so big a fall. Most agree that what we saw last week did not reflect any disastrous weakening of the U.S. economy. Instead it represented a healthy correction of an overpriced stock market. The good news was that few individual investors seemed to engage in panic selling. But their faith, and their sense of prosperity, will probably be tested again in the weeks and months ahead.

–Reported by Karl Taro Greenfeld and Aixa M. Pascual/New York, Alison Jones/Raleigh and Adam Zagorin/Washington