The Consumer Stool

Most of you have heard that the consumer is supported by a three-pronged stool that consists of house prices, stock market value, and personal income. When you run the numbers through on those crucial metrics to wealth, it is clear that American consumers are losing their ability to spend and consume.

The S&P/Case-Schiller home price index released in October showed the 10 city composite's annual decline was 5.0%, the biggest since April 1991. Stock market returns, as measured by the S&P 500, was a nominal 1.1% as of yesterday's (11/19/2007) close. Nominal personal income increased 6.8% from September 2006 to 2007. The personal income numbers are the one leg left that is supporting the consumer. If you inflation adjust the income numbers by the Consumer Price Index, real incomes have increased by just 3.3%. Even if you accept the government's numbers of annual inflation of 3.5%, you observe a consumer with diminished home and stock market wealth on a real basis, along with anemic income growth.

Some market pundits espouse the view that the third leg of the stool--personal income growth--will compensate for the decreases in stock market and real estate wealth. However, the numbers just don't add up. A 3.3% increase in real income growth doesn't make up for consumer's biggest asset falling in value. The median price for homes in the U.S. is now about $220,000. A drop of 5% means the consumer has given up about $11,500 in home equity this year. Compare that to an increase of about $3,100 in nominal income gains. Americans have become accustomed to double digit increases in stock market and real estate appreciation in the past few years. The wealth effect from rising stock and real estate values is gone. It should be interesting to see how much longer they can continue their consumption rates with their diminished levels of wealth.

It is my view that the third leg of the consumer spending stool will be kicked out from underneath as personal income decreases in the coming quarters. The evidence is clear that non-farm employment trends are heading down, and that should lead to lower incomes for consumers. Without significant gains in income and employment, consumer spending will continue to contract, and that should lead to further weakening in GDP growth rates. The credit crisis has exacerbated this trend, making access to credit more expensive and harder to come by.

The S&P 500 is still trading at nearly 17 times trailing earnings, and it's in no way discounting in a recession, which I believe is a likely scenario. I continue to believe that investors should remain cautious, holding high levels of cash and inflation protection assets.