How Long is the Way Out of the Hole?

The stock market just ended its worst week in history. This has sharply eroded families' financial security. Under rather optimistic expectations it would take about six years before families can hope to achieve the same level of financial security as they had at the end of 2007, before the latest round in the financial market crisis took shape.

Often observers will look at how long it took a stock price index after past crises to recover its previous nominal level. This approach has several problems, though. It understates the speed of recovery since it tends to ignore the fact that stock holders will also earn a dividend on their stocks and generally reinvest that dividend, especially if the money is invested in an index fund in a retirement account, such as a 401(k). It also tends to understate the speed of financial recovery for families since most families hold bonds in addition to stocks. So, the drop in stock prices overstates the actual drop in people's portfolios. Looking just at stock prices will, however, overstate the speed of recovery in financial security since it ignores that incomes also rise at the same time -- after all wealth exists primarily as an income replacement measure.

So, consider the following hypothetical scenario that better captures families' financial security. The primary figure to calculate is the ratio of wealth to income. A moderately risk adverse family will invest about 60% of its portfolio in stocks and 40% in bonds. Let's say somebody had $50,000 in wealth and an income of $50,000 at the end of 2007, or a wealth to income ratio of 100%. Since then, stock prices have fallen by 38.0%, dividends have averaged 1.6% of stock prices, bond interest rates amounted to an average of 4.3%, and wages grew by a total of 2.7% during this period. Combine all of this with a portfolio that is allocated 60% in stocks and 40% in bonds and the ratio of wealth to income amounted to 77.2% in September 2008. Financial security took a hit of 22.8% over the past nine months.

What could the future look like? Let's assume that stock gains will amount to 10% per year as a result of higher prices and dividend yields. At the same time, let's assume that interest rates on bonds will average 7% each year. At the same time, let's assume that wages will rise by 4% annually. All of these growth rates are before inflation. Put this all together and you will see that it will take a little under six years before the ratio of financial wealth to income will equal 100% again.

It could take much longer for families to recover their previous level of financial security, though. For instance, stock prices could continue to fall further or it could take some time before they start rising again. Also, families may take money out to pay bills or they may simply convert their money to cash to limit their losses. Further, some of their assets will be taken up by fees for financial services. All of these factors could substantially lengthen the time that it takes to reach prior levels of financial security.

On the other hand, the recovery in financial security could come more quickly. Most importantly, families may decide to save more, which is a little hard to imagine in the current economic environment.

No matter how families will react to the current crisis, it is important to realize that it will likely take years to recover the losses in families' financial security over just a few weeks.