Comstock Partners, Inc.January 12, 2012
"Special Report" Debt Induced Secular Bear Market-Deleveraging Continues
How This Affects the Consumer and Housing Market
The U.S. used unusual methods in handling the bursting of the "Financial Mania" of the late 1990s, the one called the "Dot-Com" bubble. Instead of letting the free markets dictate just how low the prices of stocks and other assets would wind up after the bursting of the bubble, the "powers that be" intervened. The Greenspan-led Federal Reserve reduced Fed Funds from 6 ½ % to 1% and started a second bubble, an unbelievable housing bubble. They attempted to stop home prices from declining, and the intervention generated an enormous increase in total debt ($26 trillion to $53 tn). We have discussed in past commentaries the onerous consequences of excess debt on the economy--especially when the excess total debt occurs in the consumer and housing sector. These two sectors are the main drivers of the U.S. economy and, if these sectors' debt problems are as structural as we believe, the U.S. economy will have a very difficult time recovering any time soon.
When the stock market finally broke down in 2000, we were convinced that we had just completed the largest financial mania in history and that the stock market would enter a secular (or long term) bear market. Our conviction was based on the fact that the S&P 500 traded at more than 50% higher than at any prior market peak valuation. The NASDAQ traded at 245 times earnings, 16 times the average NASDAQ P/E from 1971 to 1991. Also, almost every Initial Public Offering (IPO) rose to 3 to 5 times the IPO price, topping all other significant financial manias by a long shot. A large number of these IPOs had no earnings, while others were merely start-ups with no sales.
We knew that the after-shocks of a financial mania would result in a severe bear market that would be very painful when the market fell back to normal valuations. However, if the "powers that be" had let the free markets work and had let stocks drop to below average valuations typical of major bottoms, the pain would have been much less. Furthermore, housing markets would have also dropped to typical levels in relation to family median income. The free markets would have set the supply-demand balance, and the excess debt build up over the 1990s could have declined to manageable levels, as consumers rebuilt their balance sheets. However, that is not what took place!!!
Instead, the Fed lowered rates from 6.5% in 2000 to 1% in mid 2003 and both political parties pushed Fannie Mae, Freddie Mac and the investment banks to encourage more home ownership by people with lower incomes. There were also two tax cuts in 2001 and 2003 (mostly for the wealthy), and we entered two wars that were not financed. We also initiated the Medicare Part D (prescriptions program) that also was not financed. But, most of all, we couldn't have gotten away with this insanity without the help of "Wall Street" and the ratings agencies, as Wall Street and hundreds of lightly regulated mortgage companies packaged sub- prime mortgages which were erroneously rated AAA by the rating agencies, and sold to clients all over the world. Naturally, this also couldn't have taken place if we had any kind of stringent regulation of "Wall Street", but the regulation and regulators were so weak that there was almost no oversight of "over-the-counter" derivatives and Glass--Steagall had been repealed. Since originating banks and mortgage companies were able to sell their mortgages to third parties within 90 days, they abandoned prudent lending standards. A large number of mortgages were issued with no proof of assets or income (so-called liar's loans). Many required no down payment, allowed deferred interest payments and had low initial "teaser" rates that ballooned sharply in two years. This caused a double bubble in housing and stocks (along with an unprecedented major debt generation). And this BEGAN just 3 years after the financial mania of dotcoms of the late 1990s.
So, instead of letting the Market Forces work that could have rebuilt the consumer's balance sheets as the excess debt declined, the Total Debt skyrocketed from $26 trillion (tn) in 2000 to $53 tn by 2008. However, the $53 tn could be double if we try to keep the promises made with the entitlements like Medicare, Medicaid, and Social Security without means testing or adjusting the starting age.
Household (H/H) Debt Doubled relative to the historical Personal Disposable Income (PDI) and GDP (65% to 130% for H/H debt to PDI, and 50% to 100% for H/H debt to GDP-- see first 3 charts from Ned Davis Research, the best source of data we know). The Total Debt of $53 tn peaked when the "financial crisis" hit in 2008. To put this in perspective, it took $1.07 of debt to generate $1 of GDP in the decade of the 1970s, $2.97 of debt to generate $1 of GDP in the 1980s, $3.25 of debt to generate $1 of GDP in the 1990s, and believe it or not, it took $6.14 to generate $1 of GDP in the first 8 years of 2000s. The reason we didn't use the whole decade of the 2000s is because the first eight years was enough to send this country into a severe deflation. That brought the total debt to a screeching halt, while the private debt declined and the government debt rose strongly to offset the private debt decline (this is the way deflation typically works).
Since the Total Debt (including individual, corporate, and government) leveled off at around $53 trillion, and it is common knowledge that government debt increased over the past 3 years by over $5 tn, clearly the decline of PRIVATE DEBT was greater than $5 tn.
Debt's Affect on the Consumer
This development of private debt declining might seem to be a positive at first blush, but when private debt declines from the excessive levels it reached, the positive turns very negative. And this negative becomes much worse since it followed 2 major manias (dotcom from 1995 to 2000 and housing plus stock market from 2002 to 2007). We believe it signaled a high probability that the U.S. would enter a secular deflationary bear market accompanied by continued deleveraging! We believe that this decline has only just begun, and that the declining figures to date mostly reflect debt that is being written off by banks and other lenders. But these banks and lenders still have billions of dollars of toxic assets that need to be written down to realizable value over the next several years and, as we explain below, the household balance sheet is a long way from being corrected.
The best way to explain just how significant this private debt decline has been these last 3 years is to go back to World War II. Ever since 1945, there has never been a quarterly decline in H/H Debt (not even a dime!!). And this time period includes the terrible recessions of 1973-74 and 1980-82. However, since the 3RD quarter of 2008 the household debt declined for 13 consecutive quarters. We expect the household debt to continue to decline from the present $13.3 trillion to under $10 trillion. This will get it back in line with historical levels relative to PDI and GDP (again charts 2&3). Real Consumer Spending will probably continue to be weak-- (over the last 16 quarters it rose only 0.5%, the weakest ever recorded. And, since consumer demand is the main driver of the economy, this will be very negative for the economy and the stock market.
The consumer seemed to come back with the strong results of "Black Friday" this year, but subsequently consumer sales have backed off as we expected. Recent gains in consumption had to come out of savings, and that is not sustainable in view of depressed consumer confidence, minimal wage growth and high unemployment. Consumer confidence and consumer credit are still weak after rallying somewhat (see the NDR charts attached charts 4, 5, & 6).
Housing (second strongest driver of the U.S. economy only behind the consumer)
The predictions about the end of the housing market mess have been greatly exaggerated. Most of the housing market pundits were predicting that the end of the downturn should have been years ago. Actually, the market is continuing to decline and, as time goes by, the problems with shrinking home owner equity, continuing risky and poor loans being granted by Government Sponsored Entities, a weak jobs market, and excess inventory are not encouraging for a recovery near term.
During the period from 2005-2007, consumers took an average of $600-$800 bn per year from the equity in their homes, and spent it! This was based on the belief that home values were only going to go up, until they didn't! As a result of falling prices, this impetus to the economy has disappeared.
The number one problem in housing is negative equity (where the mortgage on the home is greater than the value of the home) and is getting worse as the home prices continue downward. Most of these problem mortgages are in the same areas that we continually read about such as Florida and California (each having around 2 million homeowners underwater). However, there are many other areas that also have problems with homes underwater. Arizona has about 630,000 homes underwater, while New Jersey, Maryland, and Virginia all have over 300,000. As you can see, the homes that are underwater actually are spread fairly evenly across the country.
President Obama has attempted to halt the slide in home prices by giving a break to homeowners that are current on paying off their mortgages but only if they have their mortgages with either Fannie Mae or Freddy Mac. Federal officials are making major changes to this "Home Affordable Refinance Program" to let more underwater borrowers qualify for refinancing. These homeowners are able to modify their loans and pay a reduced rate depending upon their current incomes.
These programs, that are initiated to prevent home prices from continuing to decline, will probably be as ineffective as previous "tax credits" for homes and "cash for clunkers" for automobiles. However, this housing program has even more problems as the total number of homeowners that could benefit from this program only come to between 1 to 2 million, while the total amount of mortgages underwater are about 11 million (or 25% of all homes with a mortgage). And if you take into consideration the homeowners that are "effectively underwater" (or have less than 5% equity in their homes) the number could be as much as 40% of the homeowners across America. These homeowners will all be underwater next year if the value of their homes drops by another 5% (and this is more than just possible, it is actually probable).
The problem with the housing market is secular and structural, and not just a typical, business cycle downturn that has occurred in the past. In fact, the past recessions post WW II were usually led out by a housing rebound. If the housing sector doesn't improve the U.S. economy will have difficulty reviving. The current rebound from the financial crisis of 2008 is the slowest on record, mostly due to the deleveraging of household debt driven by homes purchased during the housing bubble from 2002 to 2007. The fourth quarter seems to be shaping up as a fairly strong quarter for the economy, but that is now over, and we believe there will be a disappointing start to 2012. You have to keep in mind that there are still 6 million fewer jobs than we had in 2007, before the "Great Recession." And in order to bring the unemployment rate really down (not by losing participants in the labor force) we will need about 50% more than the 200,000 increase in jobs registered last month.
The FHA provides mortgage insurance on loans made by FHA-approved lenders throughout the U.S. It is the largest insurer of mortgages in the world, insuring over 34 million properties ($1.1 trillion). They specialize in insuring highly leveraged loans or loans where the buyer puts 5% or lower as a down payment. However, the FHA has become much larger and riskier as they have grown their portfolio by almost 400% since the financial crisis in 2007 and over that time period houses have fallen substantially. In fact, the FHA agency's independent auditor recently warned that there is a 50% probability of needing a bailout next year. The audit found that the FHA's reserves were less than one quarter of a percentage point. The reserves are $2.6 billion vs. guaranteeing a $1.1 trillion mortgage portfolio. Legally the housing agency is required to keep a 2% cash buffer, a target it has not met since 2008. If this decline in housing continues the FHA will join the other GSEs and add to the size of the next potential crisis.
Another problem with housing presently is the continuing lack of job creation. When jobs are created more people buy homes, and when workers are laid off, "For Sale" signs go up. And jobs are also a structural problem that is being treated as a cyclical problem. It will take a long time to replace the construction jobs lost as more and more homes were being built from 2002 to 2007. We will also have trouble replacing the manufacturing jobs lost over the past few decades.
Housing inventories, which had been a significant roadblock to a housing recovery, did decline in September, but we believe this drop was similar to the drop in the labor force (workers giving up trying to find a job) that continues to make the unemployment rate look better than it should have. As the robo signing scandal has created a false lull in foreclosures, the backlog has increased substantially, but will be coming on the market shortly. We also believe that many homeowners who have been trying to sell their homes have given up and taken them off the market since there are so few potential buyers. The latest Ned Davis Research shows the potential number of homes to be absorbed at close to 10 million homes (see attached chart # 7). We believe that this overhang of houses will not be absorbed for the next few years and this will continue to accelerate the deflationary bear market we expect. You can also see in the 9th chart, that home prices relative to median family income is not down to the norms (even with the inclusion of the bubble prices that raised the average price). We also expect that prices will overshoot on the downside after such an incredible extreme to the upside. You have to keep in mind that home prices vs. median family income reached an all time peak in 2003 and they are still above that level now (chart # 8).
Even when you get a little good news on the housing front, you can't trust it. The organization that once said that the housing boom would never burst, The National Association of Realtors (NAR) said this past week that the market collapse was much worse than originally reported. They made a drastic statistical error by overstating the sales of previously occupied homes from 2007 to 2010 by 14% (over 3 million homes).
We didn't address the global problems in this report, but if Europe and Asia continue declining, and in some cases imploding, the interconnectivity will make the deleveraging spiral much worse. The countries with the most excess debt, and also the ones that depend upon exports, will be doing everything in their power to debase their currencies in order to try to export their way out of the deleveraging cycle (competitive devaluations as seen in last chart, Cycle of Deflation authored by Comstock Partners, Inc.). The currency race to the bottom will not be a pretty one.
In sum, this special report essentially explains why we are so bearish on the stock market. It is due to all these avenues we pursued as a country to stem the decline in assets caused by the bursting of the Dot Com bubble. This left the country with enormous debt which will have to be deleveraged over the next few years. Also, the path we took in 2002 to 2007 left us with the two main drivers of the economy (the consumer and housing) crippled at a time when we desperately need a strong recovery and continued growth. Please continue to monitor the declines in "private debt" as the government debt continues to rise.