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.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.