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Economics: Are we as Wealthy as We Think?
New York: October 11, 2004
By John R. Stephenson

Maybe it's because the holidays are rapidly approaching. Perhaps it's the fact that there is an election in just a few short weeks with two overly optimistic candidates vying for your vote. Or it could be the low interest rates and the low unemployment rate. No matter what the cause, you just might be excused for thinking that things are looking pretty rosy. But are they? Well, according to the numbers, we are wealthier than we have ever been. The reason? Mainly because our homes have risen in value faster than our technology portfolios have been tanking. But are we really as wealthy as we think?

In the U.S., housing prices have gone up some 40% since 1995 and in the U.K. the situation is even more remarkable with house prices up 120%. To be sure, that is pretty impressive but against this positive backdrop are some less robust economic indicators. Since November 2001, the trough in this recession, wages and salaries in the private sector have risen by 2.8% in real terms versus 10.6% in the six previous recoveries. Add to this the fact that, over the same period, consumer spending has surged by 9%. When measured as a percentage of GDP, spending is at an all-time high but wages and salaries (as a percentage of GDP) are at multi-decade lows. Americans are spending three times faster than their incomes are rising. Is this a path to riches? No.

But how is this possible? We are buying everything we can on credit, foolishly believing the spin from the politicians and their underlings (government economists) that the economy has turned a corner and that we are in for even better financial times. Lured by low interest rates and a chorus of positively giddy economic news, we have been buying up houses at a furious pace and then taking out loans (home equity loans) to buy more low-priced trinkets manufactured in China. Last year, the amount of "equity" that Americans took out of their homes totaled six percent of their incomes. Of course, the situation in America is the exact mirror opposite of the situation in China. The Chinese save and invest where we spend and borrow. So accustomed have we become to rising house prices that a recent survey by Shiller and Case found that the average expected returns from house prices is an annual return of between 12 and 16% a year. This flies in the face of common sense when you have an economy that is growing at only three to four percent but serves to underscore the love affair we have with our homes.

Recently, the respected British magazine The Economist examined the wealth effect and concluded that it was largely an "illusion". The reason for this conclusion? Rising house prices do not increase real wealth for society as a whole but merely represent a redistribution of wealth. The capital gain of the homeowner is just offset by the increased future living costs of non-homeowners. The only way to truly increase societal wealth is through job growth, profits and savings. The illusion works because it is exactly what we want to believe — that we are getting richer when in fact we are getting poorer. Anytime your expenses outstrip your revenues, people, corporations and governments are getting poorer not richer. When will the illusion turn into a nightmare? It is hard to say. But when asset prices start to fall (and house prices do drop) or consumer confidence wanes, the illusion will be shattered.

Not only will the illusion be shattered, but many people will see their paltry savings wiped out as their debts remain constant but their assets (house values and stock portfolios) fall. As long as we continue to spend not only more than we make but what we expect to make in the future, we are headed toward economic disaster. At some point, the game will be up. The Asian countries that have supported our currency by buying our government bonds will eventually want to be compensated for their hard goods with something better than a paper currency in decline. Or perhaps, the catalyst will be the slowing of corporate earnings which will send the stock market lower and send us scrambling for cover.

The solution to this problem? Spend less than you make, save the rest and invest it in sectors that are likely to do well. One idea would be to invest in energy and resource companies that are likely to benefit in a declining U.S. dollar scenario. Another crucial survival skill is to be sure to pay down debt as fast as you can.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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