🤑 The wealth effect

Hey hey, happy Monday! 

First, a programming note. I’m 29.5 weeks pregnant with twins and slowing down a lot these days, so my last OptimistiCallie post before maternity leave will be next Monday (November 17). Beyond that, I may publish here and there with thoughts I can’t get out of my head, but I’ll be offline for the next 5-6 months taking care of two little aliens.

Today, a 6-minute read on a curious theory circulating Wall Street. The job market isn’t great, but are we now in an era where rich people will keep spending because their portfolios are doing so well? How powerful is the wealth effect, really?

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You can’t spell income without INCM

There are no clear rules of thumb in finance.

But this statement comes close.

The job market is the engine of the economy. Shut it off, and you’re gonna have problems.

Is evaluating a $23 trillion economy that simple? Of course not, but it’s a good place to start.

I’ve shared in the past how my perception of economic health revolves around the job market. If Americans aren’t making money, they aren’t spending money. And if Americans aren’t spending money, a recession is nearly inevitable. Consumer spending is 70% of the economy, after all.

This assumption has been battle-tested or decades. In fact, every recession since 1950 has been accompanied by a vicious spike in unemployment. 

12 for 12, a perfect record of awfulness and suffering.

Today, I’m pulling my hair out over this tenet of economic analysis I’ve believed for so long. The unemployment rate has been steadily climbing for two and a half years, and it now sits nearly a percentage point above its trough in April 2023. Americans are losing their jobs and struggling to find employment, yet they’re still spending money.

Look, I’m happy that consumers aren’t feeling too strained by the weirdness that is 2025, but I – like many other nerds – am more than confused by what’s going on here.

Maybe it’s the glut of COVID cash that households are sitting on. Or perhaps America’s richest households really are spending enough money to mask the misery of everyone else (although I think that narrative has been exaggerated a little). I’ve heard a lot of theories – from the plausible to the clearly bogus – about why the economy has been able to defy the closest thing to gravity on Wall Street.

One idea, however, ties most of these theories together.

The wealth effect, or the notion that Americans will spend more money as their perceived wealth increases. 

Or in today’s context, the theory that investments and real estate have done so well over the past few years – and are so much more influential to our financial experiences than before – that their values will encourage Americans to keep spending.

The stock market is driving the economy instead of the economy driving the stock market. The tail wags the dog, etc etc,

This idea has some truth to it. Who doesn’t feel all warm and fuzzy inside when they watch their net worth climb month after month? The wealth gained among Americans recently has been enormous, too – $60 trillion total since the beginning of the decade. Home prices are up 56%, and the S&P 500 (the index of America’s largest publicly traded companies) has more than doubled.

But as we all know, these wealth gains and warm fuzzies aren’t equally distributed. Higher-income Americans are more likely to invest and own real assets, and they seem to be the ones spending all the money lately. Some experts claim that the top 10% of earners account for almost half of consumer spending. That seems…dramatic, considering BLS data consistently confirms that the top 20% of earners comprise 40% of spending.

Shareholders’ moods are especially bright, according to University of Michigan sentiment data. Over the past seven years, stock-owning Americans have been more upbeat than those who don’t own stock, especially when the stock market is doing well. Since May, the divergence between stock owners and the rest of the respondents has been more stark than usual, potentially reflecting the stock market’s blistering rally since April’s tariff scare.

Higher confidence can lead to different financial decisions, that’s for sure.

Look through these pieces of evidence and it’s tough to deny the power of the wealth effect in good times and bad.

But can the stock market’s hot streak keep the U.S. economy afloat if the job market is sputtering?

That’s a little extreme.

For one, high-income Americans have long owned a disproportionate amount of stocks and real estate, yet this fact hasn’t shielded us from particularly nasty recessions.

As of June, the top 20% of Americans by household income own 87% of stocks and 57% of real estate by value. The rest? 13% and 43%, respectively.

This isn’t some new-age phenomenon, though. The top 20% of earners have held at least 80% of stocks and 50% of real estate since the turn of the century. Only 60% of households own stocks and 65% own real estate, which means 30 to 40% of Americans don’t directly benefit from a few good years on Wall Street.

Also, putting your faith in the wealth effect as an economic driver requires you to assume that shareholders are spending the gains in your portfolios. We’re talking about the marginal propensity to consume as income grows, baby! Real economic PhD stuff.

The PhDs largely agree that a consumer’s willingness to spend decreases as income grows. Why? Because we all have needs and wants that come at (somewhat) fixed cost. Once you cover your needs, you don’t necessarily have to shell out for much more. Sure, you’ll splurge here and there, but you also have the option to save.

Higher-income Americans may be feeling empowered by their portfolio gains, but they aren’t immediately spending every extra dollar their stock investments kick out. Selling out of stocks can be difficult (especially if your stock holdings are in tax-advantaged accounts), and people generally think of their portfolios as long-term savings.

Yes, higher stock prices can indirectly lead to more consumer spending, but we tend to see that manifest through higher wages. You know, the job market.

Here’s the kicker for me. Sure, stock and real estate gains tend to accrue more to higher-income Americans. But each income class – from the poorest to the richest deciles – relies primarily on wages. So says the Federal Reserve Bank of St. Louis, based on the latest Survey of Consumer Finances.

This is a broad statement, of course. We all know the retired uncle living off his portfolio, or that kid from high school who hit the jackpot by selling his metaverse business to a big tech bro. But for the most part, Americans’ incomes are heavily dependent on their jobs.

This is why unemployment spikes can be so pernicious. Lose your job, and you immediately lose your largest source of income (and your purpose in this capitalism machine). Some of us may enjoy a higher net worth from a soaring stock market, but (nearly) all of us have a reason to panic when the job market crumbles.

I’ve thought about the interplay between the job market, the stock market and the health of the U.S. economy way too much. I often go back and forth on whether I’m wrong to feel nervous about stagnant hiring when the AI trade is dominating headlines and investor conversations.

I’ll go through this exact string of thoughts, then remind myself that the job market is in an exceptionally weird – and maybe not overly terrible – spot. Hiring is the slowest it’s been in a while, yet layoffs are too (although you can make an argument that they’ve picked up ever so slightly this year). There’s a reason why unemployment isn’t spiking yet.

There are a lot of cope reactionary theories out there to explain the weird disconnect between stock prices and the disjointed economy we experience every day.

For now (and always), I’m trusting the numbers.

Thanks for reading!

Callie

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