Will Dunning, Chief Economist for the Canadian Association of Accredited Mortgage Professionals (CAAMP), of which I am a member, wrote an article for the Mortgage Journal called “Keep an Eye on Wealth Effects”.

What is the ‘Wealth Effect’?

It’s really all about perception…. our perception of wealth, particularly with respect to the value of our homes and equity portfolios.

As these grow, we get an increased sense of being better off financially.

True? Perhaps, but the money is not in the bank.

We tend to see this growth as another form of income. And even though we don’t receive that income per se, we sometimes begin to act as if we do.

Thus we may well reduce the amount we save, or even borrow more; and we increase our spending.

The good side to all of this is that we are, in effect, stimulating the economy. The bad side (potentially), is that both the real estate and stock markets can go in the other direction.

As we well know, a large drop in the stock market can adversely affect the housing market. We witnessed this through the latter half of 2009 and the early part of 2010.

Now I am really a ‘glass is always half full’ kind of person, but it sometimes amazes me to see people’s reaction to economic conditions, particularly when things are seemingly going well.

We seem to think it will always continue. To this end, we have very short memories indeed.

Just think about gas prices.

Not so long ago we witnessed the demise of the SUV. How long ago was that? And now, they’re back with more gusto than before. How long did that shift in thinking take? What is this based on? Nothing less than pure insanity as far as I am concerned.

I promise you this trend will be reversed in the not too distant future! However:

  • Do I know where the real estate market is going? No.
  • Do I know where the stock market is going? No.

However, I can say for certain that anyone who tells you they do know is fooling themselves!

(You may like to read my brief May 4, 2010 article: Housing Prices: The world view from a one-handed economist….)

Aside from speculation, stock values depend, in the long term, on corporate profitability, which is based, in general, on the state of the economy. And, as pointed out in Will Dunning’s article, profits have grown faster than the economy during the past decade, leading to a faster rate of job creation, which has pushed the housing market to record levels.

Most of the profits came from the resource and financial services sectors and since these are both going to be lower than they have been, it is widely believed to be inevitable that the housing market will be negatively affected.

It would therefore, appear that a return to a more conservative, long-term sustainable approach to real estate and equity investment would be most prudent.

A simple rule for all of us should be that no matter what the equity in our home is, we determine a budget we are comfortable with and stick to it…. regardless of what is going on in the economy.

Easy to say I know, and a lot more difficult to put into practice perhaps, but I can’t think of a better piece of advice.

(Copyright Dara Fahy. All rights reserved.)