Saturday, June 6, 2009

On Consumer Deleveraging

I think it is appropriate for us to revisit a John Kenneth Galbraith quote that I have posted before from is book, The Great Crash.

What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.
The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market and who then bought common stocks, would see their value drop to a third or a fourth of the purchase price in the next twenty four months.

We often forget that the bulk of the damage done to the stock market was not done during the crash of 1929. Then, the Dow Jones lost only 49% of the total 89% it would lose. Following the crash, was a long, winding rally spanning a little over 5 months and rising 52%. Of course, history never repeats itself exactly, and therefore the exact numbers are of little use to us. But the central concept is what is important. The Dow rallied in late '29-early '30 high enough, and for long enough that it convinced nearly everybody that the worst was over and good times were soon to return.

Throughout those 5 months there are numerous hilarious quotes from some of the most respected people of the time, including Irving Fisher, Richard Whitney, and Herbert Hoover. All of them claimed that the new bull market was real and there to stay. Fisher and another legend who made a fortune being short in '29, Jesse Livermore, nearly went broke in the ensuing years. Whitney ended up in prison for embezzlement. Hoover is regarded as one of the worst presidents ever.

With that bit of historical perspective, it should probably be of great concern to investors to see how such a similar reversal in spirits has occurred over such a short period of time. Stock market bulls accounted for over 85% of traders for much of the last two weeks according to the Daily Sentiment Index - highs not reached since the Oct 2007 peaks.

As I pointed out a few weeks ago, it is very easy to see that the areas of improvement (now known widely as "green shoots") are primarily in the areas that the Fed has decided to intervene and essentially become the market. Other areas of what looks like improvement appear to be nothing other than speculation fueled by government giveaways. For example, Merrill Lynch analysts have been feverishly upgrading the REIT sector after Merrill itself underwrote billions in capital raises by those same companies. The upgrades are seen as bullish by other brokerages who themselves upgrade the stock, sending the price higher and further enabling the REIT to raise more capital via share dilution.

To be sure, this kind of activity is precisely what Geithner and Paulson had in mind when they gifted the big banks trillions of dollars - to try and reinflate the bubble. But will it "work"? No. It's like The Three Little Pigs in reverse. The Big, Bad Wolf blew down the wood house in the fall, and they have scrambled to build a straw house in its place. Building a brick house (a real economy based on savings and production) was going to take too much time, too much effort. So they built one based on speculation instead. Like all speculative bubbles, it will collapse as well. Behind the glossy surface that is easily seen, the real drivers of the economy are quietly deteriorating.

Despite the media's spin attempts, Friday's payroll data was abysmal. Gluskin Sheff's David Rosenberg had the following to say:

...the internals of today’s report, in a word, were awful. Not only are businesses still cutting jobs but they are also reducing the hours that their employees are working; the private workweek hit a new record low of 33.1 hours (from 33.2 hours in April). So, total labour input was much weaker than the headline payroll suggests and this is vividly illustrated in the aggregate-hours worked index, which fell 0.7% MoM and something ‘green shoot’ advocates will not like discuss since this was actually worse than the 0.3% MoM drop in April; this takes the three-month trend to a -8.6% annual rate. Think about that for a moment because what goes into GDP is total hours worked and productivity — so the latter better continue to hang in there or else we are going to be seeing some nasty output data going forward that may well take Mr. Market by surprise. Put another way, if companies had held hours worked constant in May instead of cutting them, to achieve the total labour input they achieved last month would have required — get this — a 927,000 payroll cut. ‘Green shoot’ indeed.
(emphasis added)

Rosenberg is focusing on the correct driver of the economy - productivity. And right now, productivity, wages and employment are still declining as if government stimulus never occurred. Brian Pretti is out this week with another comprehensive investigation. This time looking into wages and incomes. From the article:

The concept that deleveraging is a big macro construct of the moment. We see it directly at the household, corporate and financial sector levels. As a counterpoint, it’s the government who is leveraging up to try to maintain price and broader economic stability as an offset. Directly to the point, in an economy very much dependent on consumer spending, absent households releveraging their balance sheets (which is absolutely not occurring, nor will it), the character of wages, salaries and broader personal income growth becomes the key driver of a potential forward consumer spending and broader economic recovery. US economic recoveries in recent decades have shared three identical character traits – pent up demand for houses goosing purchases and ultimately new construction, pent up demand for autos goosing purchases and ultimately new production, and consumer credit balances taking off northward in an environment of renewed optimism. For now, these three character traits are missing from the broader economic equation. The deleveraging process occurring directly before our eyes at the household level tells us that the character of wages, salaries and personal income takes center stage in the potential for a consumer led US economy recovery, or not. Could this very set of facts and the eventual broader realization of these facts be the basis upon which another potential leg down in the economy and markets occurs? For now the financial markets have a head of steam. Momentum and the gravitational pull of the markets upon those underweight their asset allocation mandates is driving the short term. Important to realize just what we are looking at.
(emphasis added)

Pretti then goes on to discuss a number of different measures of the labour market accompanied by some very relevant charts. A few of them below:

First is the Employment Cost Index. This incorporates wages and benefits together. Never in the 25 years of this data have we seen incomes stagnate like they are now.

Second is a chart of personal incomes from assets including interest, dividends and rental streams. Again, never in the history of the data, this series going back 50 years, have we seen such damage being done to household balance sheets. People are experiencing net losses from their assets. (Note: the two spikes earlier this decade should likely be ignored - I don't know what would have caused those other than perhaps changes in accounting laws).

Another not so widely reported number we received on Friday was that of consumer credit. It dropped another $15.7 Billion in April to $2.52 Trillion. It was the third consecutive monthly decline. The six month average works out to a 6.6% annual decline. Again, record numbers. Below is a chart courtesy of Calculated Risk.

To get an idea of how important consumer credit has been to the economy, let us take a look at the cumulative buildup of consumer credit over the decades. Here we can see that starting in about the mid 90's, nearly $2 Trillion in consumer debt has been building up. It should go without saying that this was never sustainable. Chart courtesy of the St. Louis Fed.

The consumer is deleveraging. In some cases, it is because they have to. In other cases it is because they want to. But unfortunately, they're not doing it enough. At least not in proportion with their falling net worth. Below is another chart courtesy of David Rosenberg of Gluskin Sheff. It measures total consumer credit as a percentage of their assets. Even though consumers have been reducing their nominal debt levels, the collateral they have behind it is deteriorating faster.

So consumers, who of late account for a good 70% of the total US economy are losing jobs at a record pace, are having their wages and benefits slow to a crawl, are reducing their total indebtedness and yet are still finding themselves increasingly worse off than only a few months previous. To me, that doesn't sound like a recipe for a rebound in consumption - which by the way has turned negative for the first time in 50 years on a y/y basis. Chart courtesy Ed Harrison of Credit Writedowns.

I would like to believe that all of the above is irrelevant and that the blip in "consumer confidence" was a signal that everything is about to turn around. But the unfortunate fact remains: "What cannot go on forever won't." On Thursday we will get the Retail Sales numbers for May. They are expected to be marginally higher compared with the previous month. Even though that will register as a ~10% drop from the previous year, I have full faith in the media to spin the number as positive.

Regardless of what happens in the short term, it should be obvious that the real driver of the economy - the consumer - has reached the point of no return. They must retrench. They must deleverage and start saving. A person in risk of losing (or already lost) their job, has seen their net worth crumble in the last year and no longer has access to the debt market must massively retrench in their spending or declare bankruptcy. Both are occurring, and in record numbers.

Talk of green shoots in the midst of all this is premature. The speculative euphoria that has resulted has been breathtaking in its disregard for risk. I do not know if it will continue past the point it has already reached. But after rallying 43% in 13 weeks, I would have a hard time chasing upside from these levels.

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dkearns72 said...

I just wanted to leave some thanks! This is a brilliantly done piece.

It's hard for people to avoid flaming these days on economic issues, and your sober and reasonable tone is such a relief. And, the thesis and the evidence are presented with such clarity to make them truly compelling.

In Debt We Trust said...

Great piece. I saw you on ZH.

Do you know if there was a seasonal element to the peaks and troughs of the 1930s? As in did the markets tend to rally or fall during certain times of the year?

Matt Stiles said...

Thanks Dan.

In Debt We Trust,

I don't have the statistics, but it appears that the adage "Sell in May and go away" would have worked quite well. Of course May is only an average of the ideal time to sell and November is only the average of the ideal time to buy. Sometimes the best time to sell is July, sometimes the best time to buy is July. It is only something that works over long periods of time and is not helpful in trying to time the market in one specific year.



Anonymous said...

(Note: the two spikes earlier this decade should likely be ignored - I don't know what would have caused those other than perhaps changes in accounting laws).

It's the 2004 Microsoft $30 billion cash dividend and its reversal in the data a year later.

Unless the charts are labelled real or nominal, it's difficult to interpret them. For instance, in a high inflation period, you would expect credit (or incomes) to advance at a higher rate than during a low inflation period.

The only chart that makes interpretative sense is the one normalized to GDP. And against that back drop, one needs to know the debt servicing ratio which has peaked and is trending down.

I agree with the consumer deleveraging theory but most of the charts in this blog post are not particularly illuminating of the theory that the economic recovery will be tepid due to below trend growth in personal consumption.

Matt Stiles said...


Thanks for the tip on the Microsoft dividend. That certainly makes sense.

re: inflation adjusted stats. I agree, inflation clouds all statistics. However, posting real or nominal stats would not make any difference because adjusting them to the CPI is as good as useless, for prices are a faulty method of measuring inflation.

re: debt servicing. I very nearly included the recent spike in rates as a further impediment to consumer recovery. I wouldn't take its "trending" nature as a given. Falling rates have helped, no doubt, for those that had access to credit.

I do not believe that "the economic recovery will be tepid." I do not believe we will see an economic recovery for quite some time. In fact, things will get progressively worse, consumer deleveraging being only one of the factors.



Chris said...

Great article Matt!

With consumer deleveraging on its way, how does all this fit with the prices of homes? Will they continue a downward trend or are current governmental efforts enough to distort the market further?

Anonymous said...

Regarding the rate of unemployment, as more people lose employment, less people remain to lose employment. The "rate change" will appear to be improving but the pool is actually growing smaller.

Matt Stiles said...


I believe home prices have a destiny with their historical mean. 2.8-3.4x household income is typically what the price of a house has cost. Another historical average has been the price/rent ratio. This typically averages 12-16x what it would cost in yearly rent.

In most areas, we are still nowhere near those levels. Unfortunately for homeowners, historical mean reversion typically overshoots in both directions. I don't see how this time can be different.

Anonymous said...

posting real or nominal stats would not make any difference

Hogwash or cop-out? This real PCE chart changes the picture painted by Harrison. Year over year real PCE went to zero or negative in 5 of the prior 7 recessions. You would never know those data points by relying on a nominal PCE chart.

mannfm11 said...

Stuff like this keeps you on my favorites list Matt. I just wrote one of my rambling pieces on the generational dynamics site and followed your link. Quite interestingly, the matra of what I wrote and the data you presented here were in synch. But, I disagree about the consumer being 70% of the economy, but instead, over the long run, consumption is merely a result of production. In our case, it has been a result of production and credit creation, but the means of payment of the credit has been sent overseas and been put on deposit as foreign reserves in form of treasury bonds. Thus we are now faced with a financial system with no solution.

I believe the problem is that this is seen as an Ameican problem when in fact the entire world economy was built on American credit. Going forward, this will imply we need the American producer in order there be an American consumer, which implies trouble for Europe and China. The banks can create their own credit, but eventually they will have trouble cashing their own checks, ala Citigroup.

mannfm11 said...

That is a good chart anonymous. You might note if you look closely that there have been declining peaks on this consumer spending chart since the early 1970's. (for those reading, refer to the post above my post above). Quite possibly this has to do with the movement of the boomer generation into adulthood, which gave the whole game an innitial pop, but lower peaks on charts generally mean something in a technical basis.

Matt Stiles said...


I agree wholeheartedly that consumption is the result of production. And that over the long term the two must equal each other. The fact that they haven't for so long (with debt being exported rather than goods) is suggestive that the pendulum is about to swing the opposite way and Americans will soon produce more than they consume.


I'm not sure how that chart, as good as it may be, disqualifies my statement. Obviously some real stats and some nominal stats are useful. But to say that real stats are more useful is ignorant of the fact that they themselves are misleading to inflation's true impact because of the method they use to calculate inflation. Therefore, the two measurements are essentially the same as both require discretion in their interpretation.

As long as the data is used consistently throughout, there is nothing wrong with using either.

Anonymous said...

But to say that real stats are more useful is ignorant of the fact that they themselves are misleading to inflation's true impact because of the method they use to calculate inflation

Whatever. Harrison writes a good narrative but some of his charts are not convincing and even misleading as demonstrated upthread. Didn't you notice the difference between the Credit Writedown chart and the Calculated Risk chart? One is nominal, the other is real.

Let's go to Pretti's chart now. I would hope that when interest rates decline income from assets invested in interest bearing securities would decline. I would further hope than when public corporations reduce their dividend payments, dividend income would decline. In that context to say that People are experiencing net losses from their assets is confusing stocks (assets) and flows (income).

I believe that it is the darkest before the dawn. You believe that that the sun won't rise. You are too young to have such such a strong belief in the narrative.

I was a post-secondary graduate in a professional program (and I will further tell you that my entry into the labour market in the early '80s seems no different than today, although I would concede based on my experience that the economy may appreciably deteriorate from this point forward)[the old argument from authority routine] before you were a twinkle in your mother's womb.

If you choose, continue your campaign of obfuscation and data dredging. So be it. But if you believe the data conspiracy crapola, there is no point in carrying the conversation forward.

dkearns72 said...

My bet is that there's actually something deeper in the debate between anonymous and Mr. Stiles. The baby boomer generation has it's beliefs in endless self-pleasure and "we can always live for now rather than the future" solidly embedded. They'll just "manifest" that it's always darkest before the dawn.

Baby boomers aren't, and apparently cant be, ready for what's coming. I hope they enjoy eating catfood in the penurious environment that they won't even understand was their own creation.

We who will have to rebuild from their destruction already know better because we've been living in their detritus for some time now.

Matt Stiles said...


I surmise that you are correct. Generational Theory would be supportive of that.

I know the type. People like anonymous have spent their entire education and career philosophizing about how a depression can never occur with an active central bank, yada, yada, yada... When folks like myself and many others with little economic background figured out that the economy was essentially a ponzi scheme, the older generations derided us as lunatics. After 2008 happened, they have resolved to nitpicking and accusations of acting on the basis of some "conspiracy theory."

What he (she) wants is for me to respond angrily in CAPS LOCK and poor grammar, so she can simply say, "see, you're just an angry, misdirected young man without a bachelor degree. The economy is fine. It's you that needs help."

It is the last gasp of a neoclassically taught boomer generation that knows it and its theories are damaged goods.

Occdude said...

Wow, ouch Matt. You can call forward a pretty barbarous tongue when prompted.

The intergenerational conflict is an interesting topic, likely to get more heated in the coming years. My generation (gen X) is neither here nor there but in the middle. We got neglected by the "me" generation as children and now they're coming back at us in our peak earning years ready to tax us into oblivion to support their bloated retirements.

As to the market. It's due for a blowoff retracement, but I wouldn't get too short yet. There still needs to be the manic "alls clear" buy signal right before the crash. Right now, the news is "The bad news is getting less bad" and fund managers sitting on piles of cash are looking to jump back in on weakness, the wart on their fanny grows daily.

I believe however that the real move has taken place and we get chop and slop before a top, then a flop (I just made that up, not bad eh?)

Matt Stiles said...


I don't mean for it to be mean-spirited. But sometimes people fit the worst of their generational stereotypes (yes, I understand the irony - so do I) so perfectly, that I can't help but point out their ignorance to it. We all have our motives. Boomers are trying to squeeze what's left out of their retirements. Gen-X is hoping to engineer a recovery of any sort lest they waste their peak earnings years. And the Millenials are trying to look for long-term fixes to an inflationary system that is broken. This is obviously something that is in direct contradiction with the interests of the two older generations.

I make an attempt to be very open to constructive criticism. After all, I am still learning and don't ever plan to stop. But accusations of being conspiratorial because I don't go along with failed dogmas are not matters that I care to entertain.

Anonymous said...

Not all boomers are blind to the follies that brought us to our current state nor do all refuse to see our current plight. Also, not all are delusional enough that they fail to see the defacto theft that has occurred (and will occur) on their watch.

But I don't think we've seen the real problems yet. The fate that befell GM is just a harbinger of things to come. Like GM, the US has huge unfunded Social Security and Medicare bills coming due that are only starting to mount. In 3-4 years it'll be well underway and in 8-10 years we'll have far more misery than today. The boomers have the political clout and arrogance to steal even that from their children and grandchildren.

Frankly, I'm ashamed to be considered a "boomer."

But I'm in the same boat as the younger generation. By the time I'm ready for retirement there'll be nothing left -- and I'll be an old fart to boot!

Hold on to your hats boys and girls. The next 10 years will be interesting!

Fredrik said...

Hi Matt, thanks for the piece, I do enjoy reading your work. However, I feel that you havent actually added much new to the debate here. I, like most, also believe the US consumer will need to entrench substantially due to the obvious excesses. The entrenchment of this view is shown by depressed asset prices as well as lack of committment by investors to consumer equities. The consumer deleveraging analysis is well read and understood. With that backdrop I note the following: - The US consumer has retrenched at an unprecedented rate. As indeed suggested by Ed Harrisons chart reproduced on your blog; consumption rate has actually turned negative. - The US marginal propensity to save has increased sharply from 0 to 0.057 at an incredibly fast rate. The long term average most will agree is around 0.08 - 0.1. Hence the majority of the adjustment has already happend. I think it would make sense that given the scale of this economic shock that people cut back spending viciously and fast faced with the consequences of continuing spending habits. Once that is achieved I would think its natural to returnt to long term savings patterns over a longer period of time. This is why I feel that the majority of actual spending adjustments have already occurred leaving room for more normalised spending going forward. This is why we are seeing consumer confidence creeping back - also note the substantial dislocation between retail sales (still in dolldrums) and consumer confidence. I fear for the shorts that it is retail sales that will give in and move up (based on previous analysis suggesting majority of spending correction has already happend) rather than consumer confidence taking another hit. Just a thought.

Matt Stiles said...


Re: boomers. Indeed, it is not all boomers displaying these characteristics. Many of the most vocal opponents of their actions have been boomers themselves. Strauss and Howe who developed Generational Theory and John Xenakis who runs the website are all boomers. Like all generational analysis, it deals in stereotypes.


The savings rate is definitely an indicator to follow. However, like all statistics when discussing a reversion to a historical mean, we must be cognizant of the fact that they typically overshoot in both directions. We have just seen the longest, most protracted destruction of savings in the history of those statistics. It is not a stretch to conclude that we will embark on it's polar opposite - savings rates well in excess of historical means.

I am expecting the savings rate to top out around 16-18% as the social culture of frugality digs in and rejects the spendthrift ways of the past.



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