11-3-2011 What a Difference a Month Makes

November 3, 2011

The Dow Jones Industrial Average (The Dow) ended September and the third quarter of 2011 at 10,913, about where it was back in 1998. Despite its drop at the end of the month, it ended October at 11,955. That 1,042-point increase equates to a 9.55% gain in the Index. As I write this on the third day of November, the Dow has risen above the magical 12,000 mark and ended the day up 208 points at 12,044.47.  That puts it up about 10.4% in just over a month.

Note that what has changed since the end of September is that the probability of Greece defaulting on its sovereign debt in the near future has actually risen, but the value of the Dow is up over 10%. So what happened?

In the last week or so, the Commerce Department announced that the Gross Domestic Product (GDP) of the United States rose 2.5% in the third quarter, even as the stock market reflected values that seemed to signal a return to recession. We now know that automobile sales rose 7.5% in October. Sales at Chrysler rose 27%. Toyota, Honda, and Nissan all reported that the reason they did not hit high sales levels was that they had a shortage of cars! You may recall that about a year ago, I wrote that based on a J.D. Powers survey, Americans were likely to be in the position of wanting to purchase more cars than we had the capability of producing sometime within the next few years.

In the GDP report, the Commerce Department noted that consumer spending rose 2.4% in the third quarter, even as the consumer confidence polls reported that those same people stated they were not increasing spending. A closer look at the rise in consumer income and spending reveals the reality. In both August and September, American saved or paid down debt to the tune of just under half a trillion dollars per month ($479 billion in August and $417 billion in September). Americans increased their purchases primarily in the area of “durable goods” at a rate of 4.1%. We effectively did not spend more on buying prepared food at restaurants and decreased our spending on clothing and footwear. The biggest increase in dollars was on “Furnishings and durable household equipment.” Apparently, those surveyed people who were so gloomy considered buying washing machines and cars as something other than spending money! The same appears to apply to at least some credit card purchases.

Yesterday, the MasterCard Corporation reported its profits rose 28% in the third quarter. MasterCard and Visa derive the lion’s share of their income from transaction fees on credit card purchases. Given that the card companies have very real dollar data to report and the Commerce Department makes estimates, my guess is that the economic activity of the American consumer is rising a lot faster than the government recognizes.

It’s the Debt Service…

So what does all of that mean? As I wrote last year, we have been paying down our debt. Most of that half trillion dollars per month we have been “saving” has really been going toward reducing debt. The latest month for which the Federal Reserve has released data on consumer debt is August. In August, consumers were reducing their total debt load by 4.6% per year. Since late 2007, consumers have reduced the debt load they are carrying by about 18%.

The amount of debt we are carrying on our credit cards, mortgages, car loans, and everything else is not as important as the percent of household income that is going to service that debt. The graph below reveals where we were as of the end of the second quarter of this year (June). As of the end of June, consumers had reduced their collective monthly debt service from 14% of income to around 11%. All the evidence suggests that the decline continued through the third quarter and into October.

There is a very important message in the graph. The last time we had a recession and unemployment like the one we see now was in the 1980-1982 period (resulting in the election of Ronald Reagan). We had another economic rough patch around 1992-1994 (resulting in the election of Bill Clinton). Our debt load is very nearly down to where it was at the bottom of each of those recessions. It also means that our next President will likely be a Republican. We typically over spend and create too much debt under on President, and then pull back and have a “debt-hangover” under the next one and, of course, blame him.

If history is any guide, then we are now about where we “bottom out” in our debt reduction binges. In other words, the carrying cost of household debt rises and falls with our perception of how well we think things are going to be in the future. When we are pessimistic, we like to get our debt load below 11% of income. When we are euphoric, we can push it up as high as 14%. When we redirect our income to reducing that debt load, we dramatically reduce the things we are buying in the economy and we have a recession.

Another clear message that the graph above reveals is that the greater and more steep the decline in household debt, the more severe the economic decline appears to be. Note that I wrote, “appears.” As of last month, the GDP of the United States was back to the same level it was at its peak in 2007. That officially signals that we are no longer in “recovery,” but now have moved into “expansion” in the total economy. With over 9% official unemployment and probably around one in five persons who want to work either unemployed or “under-employed,” the consumer side of the economy (where we live and experience) does not feel “recovered.”

Consumer Debt is the Key

While the total percentage of our incomes that go to pay on our mortgages has fallen a bit, the big decrease has been in “Consumer” debt, which includes car payments, credit card payments, and the like. Once again, note that the data here only goes through the end of June. At that point we were at the consumer debt level of the early 1980s and were working our way down to where we were in the early 90s. If the trend continued, and all the evidence I can find suggests it did, then we should now be about at the point where we will start buying again. Sure enough, in the last part of the third quarter we started buying cars and other “capital” items and the credit card companies reported significantly increased activity.

Perhaps the most important thing to take from this chart is the trend line. At the current rate of debt pay-down, we will hit the 4.5% level by the end of next year. That is the point where we opened our pocket-books and started spending in 1994, triggering one of the greatest economic booms in our history. Because of the nature of the way things change, we should actually see a leveling off starting this year, accompanied by an increase in consumer spending.  In fact, we may have just seen the beginning of that reversal with MasterCard and Visa reporting record earnings. Based on the debt service load data, I would not be surprised to see the bottom in the housing market occur in 2012. When houses begin again to appreciate is another story, and a very difficult thing to predict.

Federal Debt Service

There is a lot of light and noise about the federal debt. From what I have seen it is the most popular ring in the political circus right now. Factually, it is not at all what it is made up to be. Just as with consumer debt, the quantity of dollars is not the important number to watch, rather it is the cost of that debt as a percentage of income. The most common way that a country’s “sovereign debt” is measured is by the relationship of the total governmental debt as a percentage of the total output of the nation (GDP).

The reality is that the debt-to-GDP relationship, within limits, is irrelevant. Using numbers we can get our minds around, let’s discuss a debt in the thousands instead of trillions. If a family has a net, take-home income of $80,000, but has a total debt (including home mortgage, car loans, credit card balances, and perhaps student loans) of $100,000, your first impression might be that they are in deep trouble. In fact, presuming they are a relatively young family with children, a house, and all the things that go with that, they may be in great shape. The key to determining whether they are in danger or quite well off is to know the interest rate on that debt and the number of years they have to pay it off.

If the debt they are carrying has an effective interest rate of about 3.75% (gross interest minus the tax deductions), and an average debt maturity (payoff) of 12 years, then they are actually carrying an annual debt service load of just over 13%. That, by the way, is the historical norm, and really quite healthy.

Now let’s switch perspectives and think of the federal government as if it were our hypothetical family. In terms of billions of dollars, our government takes in about $2,250 per year ($2,250 billion). The crucial number is the debt cost to the government on debt held by someone other than another government agency, or as it is officially called “debt held by the public.” The interest rate on that debt averages 2.886% per year. The public debt stood at $1,256 billion as of the end of October. That means that the interest the U.S. Government is obligated to pay is just under $300 billion per year, or about 13% of its revenues. Yes, that is only the interest on the debt, and eventually we will need to pay down some (but not all) of the principal.

One more detail and I will move on. Government revenues are down, way down. When tax rates were a bit higher and the economy was humming along in full expansion mode in the 1990s, the federal government took in about 20% of the total GDP. Currently, federal revenues are down to about 15.5%. Part of that is the income tax reductions that were passed and signed into law during the last decade and part is the fact that it is the taxable part of the economy that is still at below normal growth. In very real terms, the government took a pay cut of about 1/3 at the same time it needed to increase spending to support some of its children (citizens) who lost their jobs. It is also facing a growing cost to take care of its ailing parents (senior citizens). Since our government has a truly outstanding credit report, it can borrow money at less than 3% per year, so that is where it turned to get the difference. Its condition is not a heck of a lot different than many American families.

In short, the federal public debt could get out of hand if we do not address it, but it is currently not a serious problem. It is a popular issue to worry about though. There are actually quite a few ways to get it under control. Unfortunately, they all equate to a combination of cutting entitlements, mainly to older people (which the Democrats will not allow) and increasing taxes (which the Republicans will not allow), so we are stuck until we conclude that both are necessary. Just as in our hypothetical family, there may be a need to reduce spending and if that is combined with a change in employment somewhere in the family, leading to higher income, then things will probably turn out well.

As much as I hate paying taxes, and I write checks to the IRS each year that make me shudder, the fact is that we tend to do best as an economy at about the 18% (of GDP) federal tax level. A 3% increase in revenues combined with the economic recovery that is likely to be about to take place will go a long way toward getting us out of the woods. We also need to deal with the issue of health care for terminally ill patients. At present the largest single expenditure of our spending on health care is done in the last two years of a person’s life. There is no evidence that the people on whom that money is being spent are benefiting from it, but we can say for sure that the rest of us are likely to suffer from the expenditures. We have a system that cannot refuse a next-of-kin’s demand to spend an effectively unlimited amount of money on a very elderly dying person. I don’t know how we can fix that, but we must.

The Stock Market

As I write this, the Standard & Poor’s 500 Index stands at about 1,261. So far this quarter with 327 of the 500 companies on the record for the third quarter, 218 had better than expected earnings, 72 were below expectations and 37 hit the estimate. That puts 67% of the reporting companies with earnings higher than expected. More, the reporting so far indicates that both operating and “as reported” earnings are going to break all previous records. In short, corporate earnings are at an absolute record high. Meanwhile, the Index itself is about 20% below where it was in 2007 despite the fact that reported earnings are 20% higher than they were in 2007!

In rough terms, that means that the stock market value is effectively 40% below where it was in 2007. Here’s the most fascinating thing, at least to me, about that set of numbers. The stock market was not overvalued in 2007. If the market was at the same, quite reasonable, price to earnings (P/E) ratio it was in early 2007, the Dow Jones Industrial Average would be at nearly 17,000 and the S&P 500 would be at about 1,700. Just for the record, the price to earnings ratio back in 2007 was 17. In 2001 it was at 45! The historical normal level is between 17 and 20. The current P/E ratio is around 10.

Translated into percentage yield, the Standard & Poor’s is currently yielding a whopping 8.26% per year in the form of corporate profits (earnings). The vast majority of that yield is being reinvested back into the companies, as it well should be, but still that is a heck of a high yield. In fact it is the highest it has been since 1982. By any definition, the stock market is the cheapest (most undervalued) it has been in thirty years. Oddly, because of the amazing increases in annual profits, the stock market in the United States is actually lower in terms of absolute value than it was in March 2009!

That value imbalance is present not only here in American, but is even more pronounced in the the emerging market countries. Emerging market funds fell further than the major U.S. Indexes in the third quarter, and as they tend to do, appear to be coming back faster. The Vanguard Emerging Markets Stock Index is up about 14% in just over a month.

One last piece of good news regarding the market, although perhaps not too good if you are out of work: Companies in the United States reportedly increased their productivity by 3.1% last quarter. That fits quite well with the news that companies have continued to purchase capital goods; things like computers, machine tools, and the like. It means we are capable of making more goods and providing more services for less expense, which increases the profits of publicly traded corporations, but means they can make more with fewer workers. In effect, it means that the stock market will probably do much better than the job market in the near future.

Greece and the Eurozone

So, what does that have to do with Greece and the Eurozone? As I have written before, Greece is going to default on its debt. The agreement that was reached last week among the member nations of the European Union was that each nation would supply a Euro guarantee amount to a fund that would back-stop the bonds of the other troubled nations, Italy, Spain, Portugal, Ireland, and Belgium. Second, the agreement was that each nation would put the pressure on local banks to take around a 50% “haircut” on the value of Greek sovereign debt. That meant that the various nations would step in and shore up the banks’ reserves to compensate for the losses they would book from the debt write-down. Because the write-off of half of the Greek national debt was to be “voluntary” there would be no triggering of the credit default swaps (CDS), which are, in effect, insurance policies against the failure to pay in full by the Greek government.

Another thing that initially sounded quite good was the agreement by the EU countries to “guarantee” a fund that was intended to attract outside investors to boost the value of the internal fund. In essence, the European financial stability fund would borrow money by issuing bonds to backstop the bad debt of the southern tier of Eurozone countries. Unfortunately, the European Union only reached an agreement to “guarantee” those new bonds at 25% of their face value. Frankly, I don’t think they are going to get a lot of takers.

It is those CDS obligations that have markets running scared. It is good to remember that it was the CDS obligations issued by AIG (a life insurance and annuity company) that nearly took the whole system down in 2009. AIG had assumed that Lehman Brothers would make good on their obligations or that the Federal Government in some form or fashion would “bail them out.” When the decision was made by the Bush administration to let Lehman Brothers go down, it caught quite literally everyone by surprise and the ripple effect nearly took the entire world financial system down too. Note here that it was not the failure of Lehman Brothers that nearly brought the house down, but the potential for failure by a United States life insurance company that was making a fortune selling annuities to risk averse investors.

The concern is that either one of the Eurozone countries or now perhaps Greece itself will pull out of the deal and in doing so effectively render the Greek sovereign bonds worthless. That very fear was the deciding factor in the failure of MF Global Investors, LLC this week. There will be repercussions from that failure as well, but note that in the ensuing days, the Dow has risen about 5%. MF Global, as it turns out, took a big position not in Greek debt, but in Italian and Spanish bonds. Worse, the attempted sale of MF Global fell through at the last minute because of “discrepancies” found in MF Global’s books. Those discrepancies now have been admitted to as illegal use of client funds by the firm.

There are two very large lessons here.

First, the decision by the Greek government to hold a referendum on whether or not to accept the terms of the Euro bailout (which has now been rescinded) meant that Greece would probably default in a very uncontrolled manner and is pretty much a worst-case scenario. On that news, the Dow dropped 5% over two days before starting to rise again. The lesson from that event is that the traders on Wall Street have finally figured out that just about everyone concerned has made provisions for the Greeks to default. When it happens it will not be a Lehman Brothers. It also shows that The folks on Wall Street have concluded that the Germans and the other Eurozone nations with a few Euros to spare will not allow the Greek failure to spread to Italy, Spain, and so on.

In short, the first lesson that we can learn here is that the movers and shakers in the stock markets of the United States have concluded that a rolling series of defaults across Europe will not mark the end of the world. Sure, we do some business with Europe, but not a heck of a lot. Our main trading partners are here in the Western Hemisphere and across the Pacific, not the Atlantic.

The second lesson is far closer to home, and extremely critical to understand. MF Global had attracted a lot of investor money because they offered a promise of much higher interest rates than were available elsewhere. They were proud of their “managed futures” program, which offered the lure of a mystical ability to make money in falling markets.   Those “high net worth” investors who took the bait are now listed as “unsecured creditors.” Sadly, some of the investors will probably turn out to be anything but “high net worth.” because MF Global also was heavily marketed as a source of “privately managed accounts.” They often marketed their programs to “reduce portfolio volatility” through other firms and individual “advisors.”

The Greek tragedy and MF Global’s collapse are two faces of the same coin. There are no secret ways to get a high return while eliminating market risk. There are just ways to raise your risk of total loss as an alternative to seeing the volatility, or variance that is part of the price we must pay to potentially have a higher return in the long run.

The Germans, among others, allowed Greece into the Eurozone because they concluded they could very profitably sell what was made in Germany to the Greeks, along with the Irish, Portuguese, and others. They also concluded that German banks could loan money to the Greeks to buy those expensive German goods and would earn above normal returns because the Greeks would be so thrilled to be allowed to borrow and buy that they would pay the high rates. If that sounds familiar, all you need to do is substitute one of the now failed Wall Street firms names in place of “Germans” and substitute “Americans who couldn’t afford them” for the Greeks. Here we sold houses. They did that in Europe too, but they also sold a lot of anything made in Germany on one of the other “rich” countries.

The money to do all of this came from investors who wanted a high return without risk. The idea was that by buying Greek sovereign bonds they were able to get a much higher return, but that Germany would ultimately back the Greek government if anything went wrong. The search for high returns without market risk that is probably the single most deadly investment error that anyone can make.

Here in the good old United States of America, the marketing blitz is on to get people who have had a dismal return in the market for a decade to turn their money over to privately managed accounts so that genius managers using secret formulas can work their wonders. Bernie Madoff certainly did a magnificent job of that. The other siren song is coming from the insurance companies that are promising a completely secure, steady return via the plethora of “guaranteed” annuities they are offering. The problem is that if the insurance company goes under, who will replace your money? In most cases, the answer is “no one.”

Again, the rescue of AIG by the Treasury is what stopped the collapse. What the news media did not well publicized is that many of the major annuity-issuing life insurance companies also required a rescue by the Treasury or the Federal Reserve in the weeks that followed.  Since then, the Congress has effectively blocked the Treasury from doing that again. I strongly suspect that the next time a major insurance holding company is on the verge of failure, the government will not step in and rescue it. There will be a lot of pain associated with that inaction. My recommendation is that you avoid that trap.

If you are afraid of market variance and want security, go to the bank and buy a certificate of deposit. Yes, you will get at most about 1.6% per year, and that only on “jumbo” CD offerings for five years. If you are willing to put up with market variance to have the opportunity to get that higher rate of return, then stick to mutual funds. Yes, the market may move around, both up and down, a lot, but if your money is in mutual funds, you have the protection of the Investment Company Act of 1940 against having the creditors of some management company getting first shot at your money. More, make sure if you use a brokerage account to hold the funds that the account is fully insured by someone other than the company running the account.

These are basic issues, but it is now, just as things seem darkest, when through greed, fear, or both, charlatans will be more than happy to take your money and promise you the world. Beware, because they are out there. The stock market is cheap and (in my opinion) due for a rather significant increase in value in the not too distant future.

Until next time, take care. Enjoy life. Give thanks for all our blessings.

As always, feel free to write or call with your comments or questions.

Jeff McClure