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The Sticky Luxury Lifestyle

“More prosperous shoppers seem to be defying continuing high unemployment levels and economic uncertainty to renew their spending on luxuries such as jewelry, fashion and cosmetics,” we read in the Financial Times this morning.   This would seem to be consistent with the long chain of positive earnings releases thus far in 2010.  Just last week LVMH, owner of the Louis Vuitton brand among others. reported that demand for its high-end products accelerated towards the end of 2009.

So what gives?  Isn’t this supposed to be a “rich man’s recession?”  There are a couple of important points to be made here.

Yes, this is a rich man’s recession. It is an asset-based recession marked by deleveraging.  A crisis that sees virtually all non-Treasury assets fall in value is going to take a bigger bite out of the net worth of the “asset rich” than of the average Joe who works for a paycheck.  When the financial world imploded in 2008, consumption of luxury goods ground to a virtual halt.  Retailers were stuck with a mountain of inventory that they couldn’t sell without deep discounting — a cardinal sin for a purveyor of luxury goods!

But once the shock of the crisis wore off, wealthier shoppers returned to their old haunts.  How do we explain all of this?

John Maynard Keynes wrote extensively about the “stickiness” of nominal wages.  What Keynes realized was that humans are emotional beings; they are certainly not the mythical homo economicus that appear in most economic models of behavior.  It’s psychologically difficult to accept a pay cut, and it’s bad for company morale.  So, when hard times strike, companies find it more prudent to keep wages at current levels and cut costs by reducing headcount instead.  Thus wages tend to be “sticky” and stay artificially high when deflationary trends suggest they should fall.

Along these lines, I have my own theory about consumption that I’ll call the “Sticky Lifestyle Hypothesis.”   Luxury goods are, for the most part, a status symbol more than anything else.  A $10 Timex watch keeps time as well or better than a $10,000 Rolex.  But it certainly doesn’t project the same image.

It is psychologically very difficult to scale back your lifestyle once you are accustomed to projecting the “right” image.  This isn’t completely irrational, either.  You might think twice before using the services of a banker or lawyer who rolls into the office in a 10-year-old Hyundai and a moth-eaten suit.  Even if it is frivolous, the image of success is an important marketing tool for a lot of professions.

Imagine the case of a hypothetical hedge fund manager or real estate developer worth, say, $100 million.  Let’s say that his net worth got chopped by 75% during the crisis, to $25 million.  Such a reduction in wealth will mean that certain status items get put on hold indefinitely.  Perhaps the yacht and private jet will have to wait for better times.  But a $500-$1000 handbag for his wife, mother, or daughter?  Those are still affordable impulse purchases for the high net worth set.  During a year like 2008, he might not be in the mood to buy them.  But once the shell-shock wears off, the American Express makes its reappearance.

I suspect that the luxury retail goods industry will do just fine in the years ahead.  The over-the-top excesses might not return for a while, but sales of basic luxury goods should be buoyed by wealthier Baby Boomers (who reach their peak spending years later than the mass market), by the entry into the workforce of Echo Boomer women who will be building out their professional wardrobes (the enormous generation graduating from high school and college today), and by the Sticky Lifestyle Hypothesis.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy