Don't Forget Newton's First Law!
By Chris Puplava, July 2, 2008
Investors would do well to remember Sir Isaac Newton’s first law of motion that states an object in motion will stay in motion unless an external net force acts upon it. The motion of the U.S. economy is clearly worsening and, as highlighted last week (As Good as it Gets?), the net force applied to the economy to change its direction by the governmental stimulus package has proven wholly inadequate. Investment decisions should be guided by a defensive posture until there are visible signs that monetary and fiscal external forces are turning the economy around, which remain decidedly absent.
There was a brief respite in the markets off the March lows where Wall St. pundits were telling us that the worst of the credit crisis was over and the economy would skirt a recession. However, Newton’s first law was still at work as the economy continued to deteriorate and the deleveraging process continued unabated. It began with the peaking of an historic housing boom that came to an end in 2005 after roughly a 15 year run. That extended cycle led to a speculative bubble that took off in its later years, driving home prices to unsustainable levels.
Despite significant home price declines, we still have a ways to go from the 2005 top as the excesses are wrung out. For example, the median home price relative to median family income reached an all-time high of 423% in 2006, nearly three standard deviations above the average seen over the last half century, quite the statistical extreme. The current value of 386% has only come down 34% of the way needed to bring the ratio back to the long term average of 312%.
Source: U.S. Census Bureau
This illustrates the point that we still have a long way to go in wringing out the housing excesses created this decade, and the housing corrective motion continues on. This will come as unwelcome news for U.S. homeowners who are hoping for an end to the housing carnage that is eating away at their net worth, who have lost $520.3 billion since last summer alone.
Source: FRB Flow of Funds
The effects of the deleveraging of the housing bubble have spilled into the economy as the economic dominoes are falling one by one. Employment has peaked, retail sales have peaked, auto sales have peaked, industrial production has peaked, nonresidential real estate has peaked, personal income gains have peaked, unemployment is rising, and defaults on various forms of credit are rising, and on, and on.
Clearly the economic deceleration that began with housing continues to spread into every area of the economy and has yet to find some form of stabilization. Wall Street has not escaped unscathed as the deleveraging process is not confined to Main Street alone as investors are also deleveraging. As there was a debt binge that drove housing prices up, there was also investor speculation that drove the stock market up in 2006 when the Fed went on pause as margin debt began to expand. Then in 2007 margin debt exploded along with the private equity bubble, rising more than 60% year-over-year (YOY), a feat seen only three times in the last thirty years, all which were associated with peaks in the market. The last example was seen in March 2000 when margin debt grew by 78% YOY, six months prior to the peak in the S&P 500. The 2000 script was played out last year almost perfectly as the peak in margin debt seen in June of 2007 came five months prior to the October peak in the S&P 500.
Source: Standard & Poor's/NYSE
As the speculative froth that poured into housing still has a ways to go to unwind, so too does the speculative froth that poured into the market as the ratio of margin debt (billions $) relative to the Dow Jones Industrial Average has peaked after spiking well north of the long term average of 16.5. In March of 2000 the ratio peaked at nearly three standard deviations from its average and corrected sharply as margin credit contracted. The ratio hit a new all-time high in June of 2007 rising to 28.06, which is nearly 3.5 standard deviations from the long term average.
Source: NYSE/Dow Jones Co.
Interestingly enough, as the median housing price to median household income has only come down 34% from the peak towards its long term average, margin credit relative to the Dow Jones Industrial Average has come down only 33% from its peak relative to its long term average. A continued contraction in margin credit will take away one of the sources of buying in the market and contribute to lower prices ahead. So now we have both a deceleration in the economy and financial markets that appears to be gaining strength, not bottoming as financial pundits would have you believe.
Pascal’s Wager: What happens if we’re wrong?
As mentioned above, the respite seen off the March lows brought with it plenty of bottom calls and “the worst is behind us” nonsense. What was amazing was that the financial media completely ignored the trends in the economy and were delusional in their Pollyanna thinking. When Wall St. became more cheerful, the U.S. consumer became even more depressed with consumer confidence levels falling to quarter century lows, leaving Wall St. pundits baffled as highlighted in the article below.
Pundits have been scratching their heads about why the public mood is so grim. Last week, Barron’s called the drop in consumer confidence “difficult to figure.” A front-page headline in The Washington Post claimed, “We’re Gloomier Than the Economy.”
But are we really?
For the first time on record, an economic expansion seems to have just ended without most families having received a raise. For the first time on record, the typical home price nationwide is falling. The inflation-adjusted value of the Standard & Poor’s 500-stock index has dropped 20 percent in the last year — and 30 percent since its peak in 2000.
I think the public has called this issue exactly right: the American economy has some real problems. Even if this summer’s downturn turns out to be mild, those problems aren’t mild — or simple — and they aren’t going away anytime soon. It’s going to take some real work.
The New York Times, July 2, 2008
Wall St. has been on the wrong side of the trade for quite some time as the subprime problem was supposed to be “contained” as was inflation. Instead of being guided by Wall St. Pollyanna bias, investors should be guided by the most fundamental aspect of investing, and that’s risk management. An excellent article on the concept was written a couple of weeks ago in The New York Times and is highlighted below.
“The key word is ‘consequences.’ I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future.
Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether ‘God is or God is not.’ Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not.
Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people.
Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.”
“RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal — encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.”
PETER L. BERNSTEIN
The New York Times, June 22, 2008
Investors should take the following advice to heart when managing their money, asking a myriad of pertinent questions in which to frame an investing strategy. “What happens if housing prices don’t stop falling this year, or even next? What if mortgage losses continue? Could we be a long way off from financial write downs? What if the governmental stimulus package doesn’t work? Will there be more to follow and what will be the impact of these on the dollar? How are Americans going to cope with higher energy and food prices? Are they going to cut back on discretionary spending items? If they do, won’t that depress retail sales even further? Won’t falling retail sales lead to more job layoffs? Won’t more job layoffs lead to more defaults on mortgages? Won’t more mortgage defaults lead to more financial write downs?"
On goes the economic spiral until some net force arrests the decline. Unfortunately, many of the economic and financial tools and options of the past are no longer there. In the 1990 recession, consumers could bring down their savings rate to lean upon and spur consumption, and the Fed could lower interest rates from a starting high of roughly 9%. To get us out of the 2001 recession, consumers tapped into their home equity and the Fed lowered interest rates to levels not seen since the 1950s. This time around, the U.S. consumer’s savings rate is near 0%, the Fed funds rate is already at 2%, the housing ATM is closed. How much lower can the savings rate go? Is the Fed going to lower interest rates to 0%?
Clearly there is more economic and financial pain ahead as the imbalances created over the last several decades are unwound, which is the primary benefit of recessions. We used to have recessions every few years, but that changed over the last three decades with recessions happening every 8-10 years as more debt was piled on to keep the party going, which allowed imbalances to build up with less unwinding. The economic and financial pain of previous imbalances has been deferred, not erased.
Throw out the ridiculous notion that “the worst is behind us.” Wall St. Pollyanna pundits" should not be taken as gospel as they have been clearly wrong for more than a year now. Instead, investors should be utilizing Newton’s first law of motion and look at a myriad of economic and financial data, looking for a pervasive turnaround in the overall economic and financial picture that symbolizes a bottom. As the preponderance of economic data continues to worsen and an economic bottom remains allusive, capital preservation, not capital appreciation, should continue to be the order of the day.
© 2008 Chris Puplava