With the FTSE 100 having recently hit a record high, the question arises: should we spend some of our profits? Certainly, history suggests there is a link between stock market movements and consumer spending. There has been a positive correlation between real annual total returns on the All-Share index and changes in real consumer spending in the following 12 months, of 0.24 since 1987. On average, 10 percentage point above-average equity returns lead to consumer spending growth being 0.3 percentage points above average.
Of course, shares are much more volatile than spending – the late Nobel laureate Paul Samuelson said the stock market has predicted nine of the past five recessions. Nevertheless, there is signal in the stock market and not just noise. As the NIESR’s Roger Farmer has said, “the ups and downs of the stock market are followed by ups and downs in employment”.
In itself, such a link does not show that we actually spend the profits of rising share prices. Rising prices are an indicator of increased confidence in the economy. That should be associated with increased spending even by people who don’t own any shares.
Evidence that we spend stock market gains comes not from macroeconomic data, therefore, but from studies of individual consumers. Amir Kermani at the University of California at Berkeley and colleagues have estimated – based on detailed Swedish data – that the wealthiest half of the population spend around five pence of every pound of stock market profits. This is quite close to the prediction of the permanent income hypothesis, that people spend the annuity value of windfall gains.
This is significant, but small. It implies that if you had £100,000 in UK equities a year ago, you will now spend £200 more than you otherwise would.
There are good reasons why the response of spending to share prices rises should be small. One is that so much hangs on how we interpret them. Since March, the All-Share index has jumped more than 12 per cent as I write. That’s a big profit. But in the past 12 months the rise has been only 4 per cent. And from a longer-term perspective returns have been moderate; since 2007 for example real total returns on UK shares have been less than 4 per cent per year. That’s no reason to go on a spending spree.
Also, of course, today’s profits might not last, Lead indicators such as the global money-price ratio or foreign buying of US equities point to shares falling in the coming months. And the lower dividend yield than a few weeks ago gives us a reason to be less optimistic about the market. It’s usually a good idea to think of higher prices as meaning lower future returns. If you’re sitting on unrealised capital gains, you might not get to realise them. Again, this is a reason not to spend.
Thirdly, a policy of not spending stock market profits is a useful disciplining device. It’s much easier to increase spending in response to rising prices than it is to cut it in response to falling ones. If we adjust spending to changes in share prices, therefore, we’ll end up with a bias to spend too much and save too little.
Personally, I have a policy of spending premium bond prizes, but not stock market profits – and in fact a £50 prize in a month gives me more pleasure than (sometimes) much larger monthly stock market gains. From the point of view of textbook economics, this is wildly irrational. It’s a form of mental accounting whereas logic tells us that a pound is a pound wherever it comes from. In the real world, however, this irrationality cancels out another irrationality – an optimism bias that might otherwise cause us to spend too much when share prices rise.
All this implies that we shouldn’t increase spending very much in response to higher share prices, and that we probably won’t. Yes, the Footsie’s rise since March might have improved the prospects for our beleaguered retail sector. But it has probably shifted it only from grim to ever-so-slightly less grim.
