Bear Market Wild Card: Testing the ‘Wealth Effect’

The average bear market decline in blue-chip stocks since World War II is 28%. If the Dow Jones industrial average fell that much from its Aug. 6 record high of 8,259, the index would lose 2,312 points to 5,950--taking it back to its levels of October 1996.

Wall Street’s deep-seated fear, however, is that precisely because this bull market has gone on for so long (since October 1990), the next bear market might take prices down far more than average because so many investors who’ve never sold could ultimately decide to exit, in panic, at the same time.

Is that a rational fear? Morgan Stanley, Dean Witter’s Barton Biggs sees the potential for a “vicious circle�: Corporate earnings decline, triggering what would ordinarily be a “normal� bear market. That, in turn, triggers a U.S. recession, because the record 50 million American families who own stocks suddenly feel poorer. Corporate earnings fall further because of the recession. At some point, massive selling of mutual funds begins as stunned investors exit in droves, driving the stock market much lower than what the underlying fundamentals would dictate.

One key issue here is the so-called wealth effect: How much of consumers’ spending in the 1990s has been fueled by their feeling wealthier as their stock accounts have appreciated? Economists haven’t been able to measure the upside effect well--so they aren’t sure how to estimate the potential downside for consumer spending, and thus for the economy, should stock prices plummet.

In any case, some market pros believe that it will take a long time and a lot of damage to the stock market to precipitate a full-scale selling panic by small investors.

Just as it has taken many years for individual investors to adopt the mind-set that they need to own stocks for the long haul, it would take an extended period of market trouble to destroy that belief and send people fleeing, argues Richard Eakle, head of market research firm Eakle Associates in Fair Haven, N.J.

“This is not something that’s going to occur overnight,� Eakle maintains, “but over the course of a year, at least�--if it occurs at all in the near term.

Even now, despite the volatility in the market in recent months, the average stock mutual fund investor is staring not at a loss this year, but at a 20% year-to-date gain.