April 2001

The Most Dangerous Bubble Of All?

Economic Cognitive Dissonance?...Dichotomy in perception is what the financial market is all about, isn't it?  At ContraryInvestor.com, it's our raison d'etre.  At the moment, we may be facing public perceptions and economic fact that are moving a bit away from the realm of dichotomy and into the post spring training ballpark of dissonance.  Maybe a fine line in definitional terms, but potentially a very expensive one...especially if you happen to be on the wrong side of the equation, of course.  We're receiving mixed messages these days.  The red neon signposts reflective of the real economy cast their messages in flashing amber light.  Signs of caution.  Signs of contraction.  Signs of economic pain.  Signs of negative stock price ticks on the unforgiving screen.

The Chicago Purchasing managers index released on the last day of March tells a story of distress.  Deepening pain for manufacturers in the greater Chicago area.  A symbolic number for an experience that has not been seen at any time during the last 19 years.  A number that foretells of a difficult National Association of Purchasing Managers Index right around the corner.

Within the composition of the number itself, components such as employment declined significantly.  Backlogs, new orders and production all fell substantially.  The anecdotes continue to mount regarding the serious nature of the current manufacturing decline.  A decline that is rapidly engulfing other corners of the economy.

The 4Q 2000 GDP report in the last week also shows that from the quarterly annualized growth rate peak seen in late 1999, annualized quarterly growth in GDP is almost 90% of the way to zero.  Sort of like a few big name tech stocks we know of.

Again, a quarterly number not seen since 1995.  Exports have declined as the dollar has remained relatively strong against our currency challenged foreign brethren.  IT spending has shown continued declines over the past three quarters.  From first quarter preannouncement vignettes, the IT drop in 1Q 2001 should be nothing short of eye popping.  With each report, the amber neon reveals a little bit more of its current tale of woe.

Chasing Shadows Into The New Day...On the other side of the Street, consumers have not lost hope by any stretch of the imagination.  The recently reported surprise increase in Consumer Confidence was completely driven by the future expectations component of the composite report:

Although current expectations remain subdued, hopes for what will happen six months out improved quite nicely over the previous month.  As testimony to the resiliency of the American investor psyche, personal income and spending numbers today showed that the American consumer is far from hibernating.  February consumer spending advanced .3%, but the bigger story was that January spending was revised to up 1%, the strongest showing in almost a year.  Personal income likewise continues to rise.  The dark spot, of course, being that the personal savings rate remains at a record low -1.3% number.  Is US consumer confidence displaying a bit of cognitive dissonance relative to what is happening in the real economy?  Clearly the answer remains to be seen in the months and quarters ahead, but we find something like the following incredibly hard to ignore, reinforcing our surprise at a consumer whose confidence about the future is apparently increasing:

Not only has what has already been announced in terms of layoffs seem quite staggering, but what is implied in current stats like the Chicago PMI does not bode well for the above chart returning to Earth any time in the near future.  As we have said, consumers continue to spend current income, even as the new era savings vehicle of choice - the stock market - continues to amble along the asset vaporization trail.  Clearly the negative savings rate implies consumers are financing enhanced spending with either prior savings or continued borrowing.

Another, and possibly more important, facet of public confidence on display at the moment is the lack of fear displayed by the retail investor concerning their stock holdings.  Last year was the first year in many a distant memory that actual household net worth declined, primarily as a result of falling financial asset values.  Maybe we are simply old-fashioned, but we would have bet good money that a compressed eleven month 65% drop in the NASDAQ would have sparked some true fear and panic selling.  Although equity mutual funds have experienced some minor outflows recently, it has been nothing short of a trickle relative to total assets held in equity funds.  Taken together, stocks have lost close to $5 trillion in paper value from the top.  The only real fear we see among investors these days is the fear of missing a rally.  The fear of not making money.  Not the fear of losing more of it.  As you may know, the supposedly contrarian bearish magazine covers that are the current buzz of the newly minted "contrarian indicator" crowd all support lead articles that are in fact bullish regarding stock prices.

The optimism of the US investor/consumer stands in stark contrast against the harsh economic reality of the moment.  There is a possibility that the US consumer may be correct in his/her assessment of the future, but it is surely far from a certainty and really a hope more than anything else at the moment.  Possibly the reason that the US investor/consumer feels the need to be optimistic about the future prospects for the economy is seen in the following snapshot of human decision making that has already transpired:

Bubble Bath...Since not long after the dawn of the new millennium, investors in the US financial markets have been showered with the educational raindrops of financial reconciliation.  Now knowing what it feels like to live through the bursting of bubbles.  As you know, although our collective experience of the last half decade has often been referred to as "a" bubble, more correctly it is a series of bubbles.  Linked by financial interconnection.  Linked by the emotional interdependence of crowd behavior.  As age begins to dissipate the warmth of the collective bubble bath, the singular bubbles that together make up the experience of the whole begin to pop.  One by one.

  The New Error

There is no question that the whole concept of a new era in the US business cycle is dying a rather rapid death.  The dotcom bubble has popped with a rather loud and expensive bang.  The investment belief that demand for technology products would experience an everlasting trajectory of straight line growth is being painfully extricated from new era philosophy and commentary.  As Alan Greenspan so deftly predicted, it's now in hindsight that one of the biggest bubbles in US history is being seen for what it was.  Quite unfortunately, this popped bubble took many a former believer with it as it so quickly slid down the slippery slope:

  The Maestro Has Lost His Fizz

A bubble we have been waiting to be popped for some time now is the "Greenspan can cure all" perceptual bubble.  As you know, this bubble may not be completely deflated yet, but a ton of hot air has already leaked out.  After all, it was only a matter of time before Greenspan was proven mortal, wasn't it?  It appears to us that the domestic as well as global economy has entered a period were the interest rate mechanism alone will not be able to single-handedly spark a change in economic fortune.  Likewise the magical levitation effect on financial asset prices also seems to be "so yesterday".

The blame game has already started.  The former savior of the financial world is now being labeled sinner for having recently dropped short rates 50 basis points as opposed to 75.  The chief Merrill economist penned a recent piece called "The Fed Fumbles", suggesting the Fed has now delayed the onset of an economic recovery due to the errant 25 basis point shortfall relative to expectations.  Quite frankly, the Fed is being forced to possibly deal with something new relative to our domestic experience of the last few decades.  A credit and liquidity driven (to which we will give the Fed full credit) capital spending boom has left the economy with excess manufacturing capacity relative to faltering domestic and global demand. The consumer credit orgy of the past decade has left the US consumer with a bloated right side of the personal balance sheet relative to a wilting left side, highlighted primarily by the "marketable securities" line item.  The debt financed stock buyback binge of corporate America during the last ten years, prompted by an ultimately vain attempt to support stock option dreams, likewise leaves corporate balance sheets as well as P&L's a bit unprepared for a new era of excess capacity in most everything except energy assets and infrastructure.

The 150 basis point rate decrease over the last three months has no parallel anywhere over the last decade-plus for this Fed in terms of the combined variables of magnitude and time.  For this call to arms, financial market participants, have responded as follows:

Although monetary policy by its very nature is characterized by its lagged influence on the real economy, clearly the "Greenspan is God" perceptual bubble is fast becoming a memory.

  The Most Dangerous Bubble Of All?

From our standpoint, one of the most dangerous bubbles of all created during this new era cycle has been the debt bubble.  When stock price bubbles burst, fallout can at best be contained within the realm of future consumption issues.  The wealth effect and it's translation into consumption through the mechanism of stock prices.  When perceptual bubbles regarding the power or influence of an individual burst, in this case Greenspan, only the dreams and hopes manifested in individual irresponsibility die. The individual dreamer is now left to take responsibility for his/her actions singularly.   No longer is there a belief that a savior can intervene on the behalf of the formerly irresponsible party.  When debt bubbles begin the process of bursting, the effects are immediate and usually quite severe.  Today, the household sector, corporate America and the financial sector of the economy are more levered than at almost any time in US financial history.  A swift reconciliation of the debt bubble with which we find ourselves would have substantially negative consequences for the real economy.  We currently stand at the crossroads of cause and effect. 

As we have described above, the financial asset price bubble and the perceptual bubble aura surrounding Greenspan are playing out in slow motion the process of popping.  The process of reconciliation.  The last major bubble that remains to be addressed is perhaps the most insidiously dangerous bubble of all - corporate, consumer, and financial system debt.  The recently released 4Q 2000 Fed Flow of funds statement details the current debt exposure of each sector of the economy.

Households

Consumer credit in the US has doubled since 1989 and tripled since 1985.  Mortgage debt has likewise ballooned over the similar period, in large part facilitated by the mushrooming balance sheets of the GSE's (Government Sponsored Agencies - FNMA, FHLB, Freddie Mac).  As you know, consumer spending accounts for roughly 2/3rd's of GDP growth.  Spending on consumer goods, real estate and financial assets.  As the baby boomers have come of age over the past few decades, the Fed Flow of Funds statement is a chronicle that more and more of lifestyle financing has been supported by debt accumulation.  The absolute numbers often seem staggering and should really be viewed relative to benchmarks in trying to derive significance and meaning.  At the moment, household debt relative to GDP has simply never been higher:

Does the above symbolic representation of the household leverage picture suggest a consumer who will be immediately responsive to a lower cost of new debt assumed?  We are in uncharted leverage territory for a US consumer sector facing a record round of job layoffs ahead.  

The negative savings rate is suggestive of the fact that the US consumer is spending in excess of personal income generation.  Clearly the savings rate calculation leaves a lot to be desired, but its application has been consistent over the period of its historical use.  Another way to look at the US household in terms of spending is to look at debt relative to personal disposable income (on second thought, maybe you want to close your eyes on this one):

We are simply convinced that the wealth effect generated by higher financial asset and real estate prices has allowed the American public to be lulled into a sense of comfort with this type of cash flow liability.  It's our guess that the recent vertical trajectory is nothing short of unsustainable.  Again, uncharted territory for an American economy grown accustomed to debt financed personal consumption.  After a year where stock market paper wealth has contracted by close to $5 trillion and consumer debt has surged by $575 billion (in the year 2000), we'd have to bet that the point of recognition is not far off.  This experience of the last year is the very definition of the danger inherent in a debt bubble.

Never in the last half century has US mortgage debt as a percentage of real estate values been as high as we have witnessed in the last few years.  Personal mortgage payments as a percentage of personal disposable income have never been higher.  Turning the first statement upside down, owners equity as a percentage of real estate values has never been lower than in the past few years:

Not only has the US consumer given up traditional savings for the new age bank accounts of the stock market and real estate, but for the last decade plus, the US consumer has engaged in the act of dis-savings in terms of real estate.  The chart above derived purely from Fed numbers accurately depicts the situation.  Every time we hear someone mention that "my home is my retirement nest egg", we can't help but look at the above chart and think that the real estate retirement distributions have already begun - far too soon.

There is one asset class that the bulk of American consumers has consistently avoided over the last 15 years - cash.

Unfortunately this just happens to be the one asset class that could ease a potential household debt reconciliation process.  This chart may look a bit worse than not as cash has been the beneficiary of a de facto decrease in percentage terms as both financial and real estate assets have risen.  Nonetheless, the unprecedented levering of the US household over the last 15 years demands more in the way of cash liabilities than ever before.  Especially onerous if we enter a period of even modest illiquidity in non-cash assets.  At the very minimum, the absence of cash holdings at the household level certainly raises the question as to the sustainability of consumer spending ahead, both in real cash terms and in the ability to further lever personal balance sheets in spending.

Corporate Sector  

Much like households, the US corporate sector is as highly levered today as just about any time in history.  Absolute dollar corporate debt has doubled since 1988 and tripled since 1985.  

During the 1990's both corporations and households were treated to a period of very inexpensive capital.  On the corporate side of the equation, IPO and VC money was unencumbered by near term cash interest payments.  Given the tidal wave of cheap equity capital available on the Street over the last decade, one might have guessed that the prudent financial course of action for corporate America would have been to delever.  Quite the contrary.  The stock option incentive system so popularized during the last decade gave corporate managements a reason to consume cheap debt capital above and beyond their needs for physical maintenance and expansion.  The debt financed stock buyback plan was simply another characterization point for the new era.  Debt used to finance common stock repurchases at prices far above levels we now see.  All in the name of creating shareholder value.  As it turns out in hindsight, for the few as opposed to the many.  

What the US corporate sector is now left with is excess plant and equipment as well as a highly levered balance sheet.  A double whammy in the current downturn.  Depreciation and interest payment levels above what would be called for under normal circumstances.  As you know, one of the major supports to GDP, in addition to consumer spending over the last decade, was corporate capital spending primarily on tech equipment and infrastructure.  Is it really any surprise that in the current downturn, balance sheet excess has caused a virtual drying up of tech cap spending?  In fact, no surprise at all.  Now that we have entered a period where issuing equity is becoming more expensive by the day (stock price declines), the process of reconciling existing corporate leverage may be much more drawn out than anything we have seen in many past business cycles.  Nothing succeeds like excess...in creating the potential for a prolonged downturn, that is.  Again, will lowering interest rates spark corporate America to lever up from here?  Been there, done that.

Financial Sector

As you know, one of the biggest enterprises of our modern services driven economy is the financing of enterprises.  A big sector of our economy doesn't really want to do anything, they just want to lend money to people who are doing something.  Clearly this is a facetious comment, but the financial sector of the US is the bedrock on which credit expansion has been built over the past few decades.  Demographically, as the boomer age bracket has embraced financing of their lifestyles, the financial sector of the US economy has mushroomed to meet that demand.  Unlike corporate debt and consumer debt, total financial sector debt outstanding in this country has more than tripled since 1990.  Remember, financial sector debt and corporate and consumer sector debt is not necessarily additive.  There is double counting here.  Fannie Mae has essentially borrowed money so it could finance your purchase of a home.  Nonetheless, the financial sector has been the moderator for defining risk in financing activities in the last few decades.  A moderator clearly focused on growing its bottom line.  A moderator possibly caught up in the idea of linear thinking.

The above chart is a historical retrospective of financial sector debt growth (on a log scale) over the past four decades with annual growth rates overlaid.  The shaded areas are periods of US recessions.  The current annual growth rate does not appear wildly out of hand, but it must be remembered that the current base of outstanding debt is three times what it was only ten years ago.  We would conjecture that the financial sector of the US economy is clearly the most vulnerable to the reconciliation of a US debt bubble.  And possibly the most unprepared.

As you know, hidden behind the scenes of the financial sector in the US is the derivatives market that presumably allows for risk management that supposedly maximizes available capital resources.  Clearly, growth in derivatives outstanding in the US banking system parallels financial sector debt accumulation:

If there are any new eras to truly be found, the financial sector in this country seems the likely candidate on which the characterization may be properly bestowed.

In our minds, the final bubble to be addressed in a much broader sense as we begrudgingly relinquish the mantle of the new era is the existing debt bubble.  Very unfortunately, this may prove to be the most dangerous bubble of all in terms of reconciliation.  It will not be easy and it will not be fun.  The question of degree in returning to some type of norm remains an open issue.  At this point economic pain will not be found only in debt default, but more importantly in the lessened ability to accumulate debt in the future.  A decline in debt through repudiation would be nothing short of an economic and financial disaster.  We're not suggesting this needs to happen.  Rather we see a dramatic slowdown in debt accumulation and a potential working off of debt to levels nearing an area simply approaching historical norms that would mean great changes for the consumption oriented US economy.  In some manner or another, prepare yourself for the reconciliation of the final bubble.  A bubble whose unwinding has the potential to wreak much more real world havoc than those experienced up to this point.