Economic Consequences of De-leveraging for Investors

By: Hans_Wagner

The explosion of credit taken on by consumers and some businesses is the major cause of the current economic problems faced by the U.S. Over the last 20 years consumer debt has risen to $2.6 trillion. In the past when the economy faltered, the consumer has been able to generate a robust recovery. Is this time different?

Growth in Consumer Credit

Consumer credit (auto loans, bank loans credit cards) has expanded in dramatic fashion over the last 30 years reaching $2.6 trillion in October 2008 as reported by the St. Louis Federal Reserve Bank's ALFRED® (Archival Federal Reserve Economic Data) database. That is $8,500 for every man, women and child in the U.S. and it does not include mortgage debt.

According to A. Gary Shilling, household debt that includes mortgages has risen from 47% of personal income in 1959 to 117% in the fourth quarter of 2007. This debt level is now 98% of the U.S. Gross domestic Product (GDP) up from 25% in 1952. Eventually this debt must be paid off.

Source of Funds for Consumer Debt

Much of this consumer debt came from mortgage equity withdrawals, which accounted for 3% of the annual GDP from, 2002 – 2007. (Sources and Uses of Equity Extracted from Homes by Alan Greenspan and James Kennedy) About one third of this money was used to pay down high rate auto loans, bank debt and credit cards. One fourth of this money was spent on consumer goods helping to push up the Personal Consumption Expenditures (PCE) of the country. Well over half of all the money withdrawn from a home's equity was spent on goods that have no lasting value.

Fueled by easier lending standards consumers pulled out the equity they had gained from the appreciation in their house's value. This money sustained the buy now life styles of many people as they spent more than they made in real income.

The total U.S. consumer revolving debt reached $962 billion in May 2008, up from $879 billion at the end of 2006. About 98 percent of that debt was credit card debt. (Source: Federal Reserve ) The average American with a credit file is responsible for $16,635 in debt, excluding mortgages, according to Experian. (Source: U.S. News and World Report, "The End of Credit Card Consumerism," August 2008)

The average college graduate has nearly $20,000 in debt; average credit card debt has increased 47 percent between 1989 and 2004 for 25-to 34-year-olds and 11 percent for 18-to 24-year olds. Nearly one in five 18-to 24-year-olds is in "debt hardship," up from 12 percent in 1989. (Source: Demos.org, "The Economic State of Young America," May 2008)

Credit has powered the U.S. economy for many years. The problem is the source of this credit is drying up and not likely to return for a number of years. Housing prices have declined and further declines are coming, possibly another 15 to 20% to get to their long-term moving average. These prices could even fall further as often prices fall below the average, before turning up. Even when they do bottom and start to move up, the value that can be extracted from them will be very limited.

Implications for Consumer Spending

Bank lending standards are tighter as bankers react to the growing loan losses in their portfolios. This means borrowers will not be able to get credit as easily as before. Moreover, bankers have raised their rates, especially for higher risk customers.

As I mentioned in my Point of Interest – More to go in the House Price Decline home values are falling and are expected to fall further, at least another 12%. Consumers can no longer count on appreciating home values to fund their spending.

It is not surprise that consumers are cutting back. The most recent retail sales figures show that all retailers are encountering a dramatic fall off in sales as consumers hold on to their cash. Sales at most every store except Wal-Mart fell with J.C Penny down 13% and Nordstrom's down 16% from the year earlier. Then there is Limited Brands, down 70%.

Leverage works two ways. It was positive for growth causing it to be higher than was sustainable. Now leverage will work in reverse putting downward pressure on growth as consumers try to pay off their accumulated debt with real earnings rather than cash taken from appreciated assets. This is likely to take much longer than many expect indicating that the economy is more likely to remain weak and in recessionary mode for longer than many people hope. In the past, the consumer was able to help pull the economy out of a down turn. Now we cannot count on the consumer to be the driver of economic growth. This does not bode well for the economy as consumer spending accounts for about 70% of the U.S. GDP.

The new government in the U.S. will try to shift some of this debt to the Federal level through stimulus programs. In the last such program, about half of the stimulus checks were used to pay down debt. While good for the long term, it did not accomplish the desired outcome, which was to re-ignite the economy. Moreover, stimulus programs increases the debt level of the U.S., which has negative consequences as well. Further, some analysts expect the new administration to incur a $2 trillion debt in 2009. Half of this was assumed from action by the current administration and half will be due to their own devices. As of the end of 2008, the total U.S. deficit was $10 trillion. Now we might add 20% to that number in one year. Our children will inherit our free spending ways, limiting their future.

The Bottom Line

For investors, the de-leveraging that continues will have long-term consequences. Some are obvious such as a weaker economy and higher unemployment that is likely to last through 2009. Companies that depend on consumer spending will be rethinking their business models to reflect the slower growth of spending. Profits will be weaker than hoped as consumers and companies work to pay down their high debt. Well-funded companies that hold large amounts of cash will become the winners as they can invest in ways to improve productivity and extend their capabilities through acquisitions.

Most likely, the market will remain in a bear market well into 2009. There will be sudden rallies lasting for weeks to a couple of months that can be traded. However, they will end the market will turn back down. At other times, there will be tradable horizontal channels that can be bought at the lows and sold at the highs. In each case the short Exchange Traded Funds (ETF) will offer opportunities if purchased at the interim highs. This means that investors cannot count on the rising tide floating all boats. It will pay to be nimble focusing on those opportunities that offer the best opportunities. ETFs, especially selected sub-sectors will offer opportunities as well. Remaining in cash is a good position if you are unsure. There will be great opportunities to make money if we do our homework.

If you would like to learn more about the economy and the key factors to understand, I suggest reading:

Economic Growth by David Weil. An easy to read book that presents the key factors to understand global economies. It is expensive and is used as a text book for college students, but it is worth the money.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2008 Hans Wagner

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