Comstock Partners, Inc.January 07, 2009
Substituting Debt for Savings and Productive Investment
It is a Recipe for Financial Disaster
By now it must be clear to everyone that the U.S. economy is dependent upon DEBT, and we believe we have reached the debt limit!! It took the resurgence of the stock market bubble in 2003, just a few years after the late 1990s bubble, coupled with the housing bubble to get the private sector to feel wealthy or comfortable enough to generate the enormous debt relative to GDP that finally froze up the credit markets. As soon as the credit markets froze up earlier this year the economy came to a screeching halt as the consumer "hit the wall" and even solid businesses could no longer borrow money.
We have been discussing the situation of the U.S. debt problem for more than the past couple of decades. We tried to explain the concept of how much debt it took to generate $1 of GDP. We published the relationship many times in the past and last published the chart in the "special report" titled, "How We Got into This Mess". We showed that it took $1.50 of debt to generate $1 of GDP for the two decades of the 1960s and 1970s, and then it averaged $2.50 to generate $1 of GDP in the period from 1982 to 1997. Starting in 1997 the debt really took off and this economy wound up taking a little more than $3.50 to generate just $1 of GDP in 2008 (the chart is attached). We recently were made aware that Ned Davis from NDR Research came up with another way of explaining this same phenomenon that we have determined is actually a better way of expressing the same thing. He measures the changes in debt for each decade in relationship to the changes in GDP and concludes that the debt relative to GDP is even more onerous than ours. His conclusion is that it took $1.35 of debt to generate $1 of GDP in the 1950s, $1.50 in the 1960s, $1.70 in the 1970s, $2.90 in the 1980s, $3.20 in the 1990s, and $5.40 in the latest decade with one more year to go. Ned Davis actually did his analysis by showing the inverse relationship of GDP/Debt (or the latest decade being .19), but the conclusion is the same.
We were warning investors about this phenomenon for the past two decades. Most investors thought that this debt/GDP ratio could continue rising indefinitely without ever overwhelming the economy and corporate earnings. In fact, the way it kept growing, we also started wondering if this could also go on forever. The total debt in round numbers is almost $52 trillion. This was not much changed this year due to the credit freeze, but rose $4.3 trillion in 2007, which was over 5 times the rise in GDP. The composition of the debt is $25 trillion in Corporate debt-both financial and non financial, $14 trillion in Household debt, and $13 trillion of Government debt-Federal and State & Local) and the GDP is $14.4 trillion. These debt composition numbers are rough estimates since there are some overlaps and double counting of financial institutions. For example a financial firm borrows the money that it eventually loans to another entity. In fact, the composition used by NDR research shows the mortgage debt (which could be under any of the categories) as 44% of the total debt composition, up from 34% ten years ago.
Over 90% of the total debt was created since 1980, 75% of the total debt was created since 1990, and over 61% since 1997. We expect the only debt sector to grow in the near future will be the Government debt due to the stimulus packages already completed and more expected as well as the bailouts. Also, if the government makes good on the promises made on Social Security and Medicare and Medicaid without some form of revenue increases this sector's debt will soar.
How it All Started
This debt cycle really started in the early 1980's when the U.S. savings rate peaked at over 10% and continued downward until this year when it troughed at a negative savings rate. There has been a slight uptick in saving over the past few months but plenty of damage has been done already. This country was built upon our savings being used to make productive investments in order to grow the economy at a sustainable rate. We have been trying to substitute the accumulation of debt for savings and productive investment and this clearly could not continue, especially since we have been increasingly dependent upon foreign sources to finance that debt.
The Reagan Administration borrowed and spent enormous amounts of money on the U.S military build-up during the Cold War (on the "Star Wars" missile shield as well as other aspects of our military complex). He did this to make sure that our superpower status militarily was maintained. We are not trying to make a judgment on these policies, but are just pointing out that this was the start of the secular cycle of lower savings and increased debt. We do believe that President Reagan made a mistake in replacing Paul Volcker as Chairman of the Fed with Alan Greenspan, who did not have the same oversight ideology as Volcker.
During the 1990s and first six years of the new millennium the Democrats, with the Republicans' blessing, did everything possible to get every American into a home whether they could afford it or not. They shunned regulation and put pressure on Fannie Mae and Freddie Mac to make homes affordable to virtually anyone who wished to own a home. This produced a dual mandate for the Government Sponsored Enterprises (GSEs) as profit making shareholder owned companies that were also urged to promote affordable housing. We are sure that the process sponsored by the administration and congress was a compassionate response to helping as many people as possible reach the American dream of owning a home. The independent mortgage companies such as Countrywide caught the disease (or saw the opportunity) of making loans to anyone who could sign their name on the mortgage applications. They were all just plainly oblivious to how that ideology would inflate the debt to GDP relationship and eventually bring down the financial community and cause the worst bear market since the Great Depression.
It was in the late 1990s, specifically 1997, when the stock market, using enormous leverage (margin debt grew from $27 billion in 1991 to $280 billion in 2000), went on a tear. This became the greatest financial mania of all times and drove equity valuations to double what they were at previous market peaks (P/E ratios were around 20 at previous market peaks and the P/E in 2000 reached 40). This mania was prominent during the debt surge starting in 1997. Examples of the mania are numerous but we will show you one that was used in the speech shown on our home page (lower left side) given at the Atlantic City Money Show in August of 2003. "Internet Capital Group (ICGE) and CMGI were internet incubators that gave advice to a portfolio of internet stocks before their IPOs. Before collapsing to penny stocks, these two companies were worth about $60 billion apiece ($120 billion combined)! This is when they were selling at $212/ share for ICGE and $263/share for CMGI. At the time this was $30 billion more than the total capitalization of all of the following companies combined-Alcoa, AT&T, Honeywell, Eastman Kodak, International Paper, and General Motors (when GM was a viable company).
What Exacerbated the Financial Crisis
After the stock market's dot com bubble burst in 2000 and it looked as if the rush to pile on debt had ended, Greenspan decided to lower rates to encourage more borrowing. In fact, in 2003 rates declined to 1% and stayed there for a whole year while he encouraged new homeowners to take out adjustable rate mortgages. This started the housing bubble which drove the price of homes from the prior peak of just under 3 times household median income to 5 times. It is presently 3.6 times so we have about 25% more to go if you assume it will decline to around 2.7 times which is the norm (see attached ISI chart) as more and more of the public got caught up in the belief that "anything connected to real estate could only go up". This drove the debt as well as GDP to higher levels and we wound up having the mildest recession in our history, when it should have been severe in order to build up business and personal balance sheets. As a result, the bear market was stopped in its tracks and a major upswing began in stocks from a very lofty valuation level---and this took place just a couple of years after the largest financial bubble in history had burst. Don't we ever learn?-and this just postponed, and made much worse, the inevitable financial collapse.
During this same period of time the consumer also largely contributed to the debt mania by going on a credit card buying binge not just domestically, but especially and more importantly, buying imports from China, Japan, Canada, Mexico, Germany, France, and all other trading partners. You have to keep in mind that U.S. consumers have been the main support for the world economy, and therefore, dominate the world economy. Our GDP is three times greater than the next largest economy, Japan, and is five times greater than most of our trading partners. And as we were purchasing the goods and services from abroad our external debt (all debt owed to foreign entities) almost doubled from $7 trillion in 2003 to just under $13 trillion presently! We had better hope, as such a large creditor that they don't give up on us as a debtor.
In 2004 the largest investment banks accelerated the debt process by asking the SEC for permission to increase their leverage from the 12 to 1 restriction to up to 40 to 1. The SEC said, "No problem". This brought on the leveraging of derivative products such as Credit Default Swaps and mortgages. Investment banks got caught up in the housing bubble. That is when many of the mortgages discussed above were sold to investment banks and were repackaged into CDOs to incorporate a mixture of good and bad mortgages. They then either kept them in their own investment portfolios or sold them to their clients with the rating agencies blessing (both here and abroad). These mortgage packages were gobbled up by everyone so voraciously because of the then convincing ideology that "home prices will not decline since you can't build new land". In our weekly comments we have predicted many times that the crisis in commercial real estate would follow.
The reason it takes more and more debt to generate the same amount of GDP is because over the long-term there are onerous restrictions on growth due to the servicing of the debt (the interest paid to accommodate it). The limits to this debt only become obvious as the weaker links in the system could no longer borrow money and as the credit crisis grows it spills over to the better risk borrowers. This is when either voluntary or involuntary deleveraging takes place. Notice that the U.S. had only six AAA rated companies as of September 2008. Paying off debt and deleveraging are the rule of the day. The misguided belief of debt being able to accomplish the same sort of sustained economic growth that was generated from productive investment fueled by savings was exposed.
In summary, the U.S. economy was driven by accelerating borrowing and spending, especially over the past dozen years, and we believe that we have reached the limits of this process. This all came to a head when the housing mania drove prices to unaffordable levels and the whole system of excess leverage was finally discredited. Now there is a panic to pay off debt and deleverage as much as possible. This, we believe, will cause a global deflation that will dominate 2009 (see attached chart The Cycle of Deflation). The bailouts and easy money will be global in nature and will probably someday cause a massive inflation-we are monitoring many indicators to determine when to invest more heavily in inflation hedges, and have a small position in inflation hedges presently. If we are correct that the deflation will dominate the global economic environment in 2009, it will be very painful for world economies and world equity markets.
This whole discussion of debt in relationship to GDP may be foreign to those of you who just want to understand why the stock market would rise or fall depending upon this esoteric subject. We believe the market will trade at around 10 times (or lower) the trendline "reported earnings" of the S&P 500. We believe this because the emotions of fear and greed do not change, and after a severe recession and bear market, we expect the trough P/E to reach the same levels that they have at similar periods in the past (just below 10 times trailing earnings of $66). The S&P 500 reported earnings have just been reduced to below $50 in 2008 and $42 in 2009 and the reductions have been consistent throughout the past year (we monitor the S&P estimates constantly and have attached the estimates made by the S&P analyst for the past year). We hope the conservative approach we've taken will cushion the bear market to ten times the trendline earnings we've discussed many times in these comments (about 600-700 on the S&P 500). We believe that the earnings estimates were reduced because of the repercussions of servicing the burden of debt loaded on the backs of corporations and the public "hitting the wall" of the same debt demon. The government is the only entity that is able to increase their debt at this time, and the way they are going we will be lucky if the dollar will remain the reserve currency. All this does not bode well for the U.S. financial environment in 2009. Our opinion of the government financial help and bailouts are expressed in "How to Get Out of this Mess", which was published in a "special report" dated 6/11/08 on our home page.
However, with all that said there is more fear of missing the next bull market than fear of losing more money. This could easily drive the S&P 500 up another 100 or 200 points and if that takes place it will be a very good selling opportunity before we resume the secular bear market that started in 2000.