January 2002

The Economic Recovery:  Debt Or Alive? 

Since The End Is Never Told We Pay The Teller Off In Gold In Hopes He Will Come Back, But He Cannot Be Bought Or Sold...It's that time of the year again, now isn't it?  Specific new year prognostications and predictions fill the financial "tabloids" from sea to shining sea.  Stock picks, interest rate calls, GDP forecasts amusingly to the tenth of a percentage point, and other assorted guessing games.  The fact is that no one knows with any type of certainty where the macro financial markets or unique assets are specifically headed at any singular point in time.  We much prefer to frame conceptual landscapes and backgrounds that we believe will exert directional force on prices over time, allowing the market itself to fill in the specific missing colors in its own paint by number dreams on a day to day basis.  It was a while back that Barton Biggs of Morgan Stanley commented that one of the major problems he observed among investors of today is that very few folks spend any time "looking out the window".  In contemplation, in reflection, in thought, in simply studying the landscape.  

At Contrary Investor, we view as one of our major responsibilities the filtering out of "white noise".  As you know, "white noise" has been in a continual bull market for about as long as we can remember.  Aided and abetted by the new era advances in technology that allow a myriad of instantaneous information at our fingertips 24/7.  A bull market determined to allow for no corrections in continual upward movement.  That we can assure you.  Our advice for a 2002 New Year's resolution?  Take a break from the boob tube and the 17 inch flat panel screen for a few moments.  Spend some time looking out the window.  There are no guru's and there are no "fortune tellers", just those who need to believe they exist.  Long term investment success is the product of the application of common sense and calm rationality. 

"The Road Ahead" Is Just An Old Cliché...As we "look out the window" over the landscape of the moment, there are a number of issues we believe will shape the asphalt highway of the financial markets ahead.  A major issue on the front burner at the moment is the perception of an academic economic recovery versus the reality of a corporate earnings recovery.

The debate now rages on daily regarding whether the economy is about to experience a "recovery" ahead.  From a purely academic standpoint, those suggesting an end to the current downturn may just be more correct than not.  Looking out the window, is sunshine filling the landscape with warmth?   Not necessarily, but what is set to happen is that the darkness in the clouds of inventories will fade to a lighter shade of gray.  It just so happens that inventory reductions during this economic downturn have been the most severe in post war history.  For durables and non-durables alike:

Inventory reduction during 3Q was a significant ($60) billon.  The inventory draw down in 4Q promises to be even worse, influenced by auto financing schemes on '01 models that drained inventory from car dealer lots and substantial price discounting among retailers.  The significant reduction in inventories is the reason why production and output have fallen so steeply over the past year.  By the end of this year, it's a very good bet that we will have seen the largest reductions in inventory on a rate of change basis for this cycle.  There will be a need probably sooner rather than later to rebuild inventories.  Academically, the sheer nature of a slowing in the rate of change in decelerating inventories will be additive to GDP ahead.  Stabilization or a mild rebuild in inventories would be a big boost to reported GDP.  The very nature of the cyclical economic beast itself argues that this phenomenon lies in our future.  Most likely in our near term future.

The question for the economy in general, and ultimately the financial markets, is whether this upcoming process will be viewed and discounted as the beginning of a trek back up the economic mountainside, or merely the initial upturn felt when hitting a mogul on the economic ski run.  A momentary uplift before continuing on down the slippery slope.  Much like bull and bear markets in stocks, the concept of non-linearity also clearly applies to economic momentum in both recessions and expansions.  Classic economic recovery ahead?  Or merely speed bump?  As you know, current stock price valuations are anticipating the former.  Maybe more meaningfully to the price puzzle equation will be the question of just how important the process of inventory rebuilding will be to corporate profitability in aggregate.

Debt On Arrival...In classic recessions past, inventory rebuilds have usually led the charge off of the trough, followed closely by a pickup in consumer spending, and ultimately an ignition of corporate spending to meet the increases in aggregate demand.  As you know, at the moment, bonds and stocks are most likely correctly anticipating the classic inventory rebuild stage.  It's post that point where the path of postwar recession history and the current experience has the greatest probability of divergence.  Staring out the window, the landscape ahead appears rough to us.  Unlike the serene backdrops to recent recessionary experience of the last four or five decades. A harsh terrain characterized by the headwinds of leverage, the cold and ice of disappointing corporate earnings growth possibilities, and the heavy baggage being carried by the consumer as the academic economic recovery journey begins.

Excess leverage in the corporate and household sectors is certainly not a new issue of concern over the last few years.  Set against this anchor has been monetary accommodation on a scale seldom seen in US history.  As one of the greatest bond bull markets in history has played out over the last twenty years, the potential ill effects of excess leverage have been kept at bay in terms of acting as a drag against economic expansion.  But it sure appears to us that both corporations and households have reached the point where they simply may not be able to hold up their end of the bargain in terms of participating in a hoped for classic economic recovery ahead post an assumed inventory rebuild.  Weighed down by leverage, it does not appear reasonable to assume a new round of corporate capital spending dead ahead.  Likewise hampered by current unemployment, above average recessionary consumption for this cycle, and debt heavy personal balance sheets, households offer little in the way of pent up demand so necessary in the annals of classic historical economic recovery experience.

It just so happens that the recent Fed Flow of Funds reports puts a fair amount of the corporate and household picture into perspective.  Rather than show you charts of absolute leverage growth, it makes much more sense to show relationships relative to benchmarks:

The Corporate Sector

For now, corporate leverage relative to GDP is simply off the charts for any post war cycle:

The corporate sector entered this economic deceleration as weighted down by leverage as almost ever before.  Leverage accumulated during the last upcycle to finance technology upgrades, capacity expansion, and used to lever corporate balance sheets while buying back equity.

We have often heard it said that corporate leverage is really no big deal as financing terms are so favorable today.  Interest rates are low.  Costs of carrying debt are manageable.  The evidence found in the Fed's own numbers argues strongly against this assumption:

We would submit that the chart above is some of the most damning evidence that corporate leverage today will impede any notion of a classic economic recovery ahead.  Although the burden of corporate interest payments were slightly higher during the early and late 1980's than is now experienced, the key differential is interest rate levels.  A similar level of interest payments as a percent of pretax profit in today's low rate environment clearly suggests that absolute levels of leverage are much higher today in the corporate arena as the cost of the leverage leaves the corporation with academically lower debt service payments per dollar of leverage.  Moreover, and this may really be the key for both corporations and households ahead in terms of the ability to contribute meaningfully to supposed economic expansion, the possibilities for future refinancing of debt relative to at any time during the last twenty years are incredibly low.  Given the already multi decade low rate structure of today, the future refinancing game at the corporate and household level is over.  There is no monetary free lunch ahead.  A high level of interest burden is a much more somber statement today than any time in the recent past.  Maybe that's why Greenspan's actions during this cycle have meant so little to so many.  As you can see in the chart above, the last time corporate interest payments were such a burden, we were in one of the early innings of one of the greatest bull markets in bonds at any time during this country's financial history.  

A final chart that reinforces the significance of current corporate leverage.  In conjunction with the above chart, the longer term interest rate history of Moody's Baa debt speaks volumes about the relativity of corporate leverage across the last three decades.  At similar levels of rates, non-financial corporate debt as a percentage of GDP has risen most significantly during the last 6-7 years.

With the corporate interest burden of the moment, that in part supports prior cycle capital spending experience, being so meaningful a detraction from pretax profits relative to historical experience, can we really expect a classic corporate capital spending cycle to reemerge any time soon?  Inventory cycle?  Sure.  Capital spending follow-on?  Don't count on it.

The Household Sector

Like its corporate counterpart, the household sector has also stretched the boundaries of historical balance sheet exposure during the recent past:

Total household debt as a percentage of GDP has never been higher in post war US history.  Certainly an absolutely crucial piece of any type of economic recovery will be consumer spending.  You know, the force that ultimately drives corporate profits in our consumer dominated economy.  Profits that ultimately translate into increased corporate capital spending.  Again, this is where the assumption of a classic economic recovery hits the fork in the road for us.  Post ever major recession of the last three decades at least, pent up auto and housing demand helped drive production, output, utilization, and a corporate profits recovery.  Our question of the moment is just what will housing and autos rebound from this time?  The following?

Additionally, as with corporate debt, many a "seer" trots out the fact that household debt payments as a percentage of disposable personal income are only as high today as what was experienced in 1987.  True, but once again the crucial key of interest rates is left out of the picture.  The last time household debt payments relative to personal disposable income were this high, interest rate exposure of the consumer was not.  Mortgage rates are just an example:

Again, much like corporate experience, households in 1987 were at the front end of major refinance opportunities.  Humble question.  How do you profitably refinance a 0% auto loan?  Do you really think the chances of refinancing a home loan are wonderful ahead with mortgage rates recently touching 30 year lows?  The only way both corporations and households get the chance for major refinancing opportunities ahead is if interest rates crumble from what are now multi-decade lows.  That only happens if the economy implodes.  Suffice it to say that much like their corporate brethren, households are as levered as any time in a half century at least and face few possibilities for P&L reconciliation via the refinance mechanism.

The Financial Sector

You know the old saying, "What's good for GM is good for America".  In the 1990's you may have thought it should have been, "what's good for GE is good for America".  Well, we're here to set the record straight.  In the 1990's, the real trick was "what was good for GE Capital was good for America".  The 1990's was all about financial sector expansion.  A financial sector that, in essence, financed US economic growth.  Lastly, and very briefly, the headlong expansion of financial sector leverage, the business of lending, may not be the conduit it most certainly was during the last 15-plus years as system wide leverage (corporate & household) is pushing extremes:

A financial sector whose conceptual raison d'etre was the expansion of that system wide leverage itself.  As macro pricing power in the economy at large has softened dramatically, the weakest links from a leverage perspective rise to the surface.  As you know, there have been more than a number of higher profile bankruptcies over the last few months.  Additionally, stress in leveraged entities such as the airlines became acute after the September 11 incident.  Lastly, and we do not mean to sound like "end of the world" mongers, the derivatives complex that underpins so much of system wide leverage expansion surely presents a higher potential for financial problems than was the case even one short decade ago.  

The recent Enron implosion is probably more of an extreme case than not, but the fact remains that the extent of financial "guarantees" now implicit in world of derivatives activities is much more meaningful today than at any time in our financial history.  

As we discuss above, the need to repair corporate and personal balance sheets just may the the Achilles heel of the assumed classic economic recovery ahead.  There will be no complete recovery without full participation from both the household and corporate sectors.  An inventory build directly ahead may give the appearance of the beginnings a classic economic resolution, but it may end up being the ultimate head fake to financial markets and economic seers alike.  Leverage may be the governor of economic speed.  We fully expect to see the reported macro economic numbers improve ahead, we're just not so sure the true litmus test of a recovery will follow along - corporate earnings growth.  For corporations, numbers will ultimately improve from the abysmal showing this year, but will it be enough to support valuations that have more than given stocks the benefit of the doubt in terms of full recovery?

There Is A Winding Road Across The Shifting Sands...One last comment for this month.  We are simply convinced that the road ahead for financial assets will be bumpy.  By that we do not mean horrific, but rather up and down.  Peaks and valleys.  The continual rebalancing of optimism and pessimism as reconciliation in system wide leverage, corporate pricing power, capacity utilization, etc. plays out.  Our take on life is that we are entering a period, and possibly a prolonged period, where asset allocation, trading and timing will be important in terms of attaining satisfying investment returns.  We're not talking about day trading, but rather suggesting one lay aside the dogmatic ideology of buy and hold for a period.  You've seen the comments by Buffet, Templeton, etc. expecting low annual returns from financial assets ahead.  We could not agree more.  But, as you know, they are referring to the broad indices.

Opportunistic investing for the individual investor remains as solid as ever in our minds.  In fact we are most likely entering a period that favors smaller pools of money as opposed to the mega institutional complexes weighed down in terms of active flexibility by sheer asset size.  For all of the somber comments we make on the economy above, and suggestions that corporate earnings growth ahead will ultimately be disappointing relative to consensus expectations, we'll leave you this month with one last picture to ponder.  CNBC recently firmly declared that we are now in a new bull market given that a number of major indices have recovered 20% from the September lows (of course, they conveniently left out the fact that most were still down double digit year-to-date).  During one of the worst bear markets seen in recent history, investors in the Nikkei had more than a few allocation opportunities:

The buy and hold Nikkei investor has lost roughly 70% of their investment since the peak over a decade ago.  The investor with the will to change stripes as the Nikkei changed stripes may have fared quite differently.  Bottom line on all of this?  Be flexible in your investment thinking as we reconcile one of the larger investment bubbles this country has ever seen.  These days we have sarcastically been telling clients that for the last ten years we could have just bought GE in their accounts and went on vacation for the decade, but in the years ahead we will actually have to get to work.  Ha ha!  Real funny.  The sad truth for baby boomers in index funds counting on performance for their retirement accounts is that we simply aren't kidding.  What happened in the US during the last decade or two is probably much different that what is to come during the next.  This goes for stocks and bonds.  The easy money days of the one of the greatest bull markets in US financial history for these two asset classes is over for a time.  That does not mean opportunity is over.  Opportunity never dies, it just changes character.