The Bottom Card
by Brian Pretti CFA, Contrary Investor. March 14, 2008
It was probably six to nine months ago when I penned a discussion entitled "The Asset Inflation Nation." The bottom line of that commentary was that US households had learned to "save" over the last quarter century via household asset inflation, especially the boomer generation that came of age in the late 1970's/early 1980's. Clearly what the boomers "learned" over the 1980's through just recently is that equities and residential real estate values "always go up over time." Of course what is implicit in this thought is that household asset inflation always occurs over time. Hence, actual savings out of income is much the rare commodity these days after literally a quarter century of learned experience. Visual historical experience explains this line of thinking better than words.
It always strikes me as a good bit funny when I hear about equities and real estate values "always going up over time," and especially from the boomer crowd. The irony, at least in my mind, is that so few realize "they were the buyers." As the boomers came of age in the late 1970's/early 1980's, they did two things that drove the phenomenon of household asset inflation. They began to consistently fund IRA, 401(k), profit sharing plans, etc. Likewise, many of their employers were right alongside them funding defined benefit and contribution plans, and the like. Let's face it; it has been a quarter century of a one-way street in terms of retirement savings contributions directed into equity buying. Of course with this tailwind, in good part this contributed to the multi-decade rise in equity prices that both helped create and reinforce the perception that equity prices always go higher. To cut right to the chase, residential real estate prices were also driven in good part by a multi-decade experience of virtually continuous boomer household formation, again leading to the popular perception that residential real estate prices always go higher. If we think about it in very simple macro terms, the baby boomers were the juice that drove the US credit cycle for a quarter century. It's really no wonder at all that the official US savings rate ultimately plummeted nose first into the tarmac.
Remember the well-worn old joke about the client and the broker? Client calls the broker and says lets buy XYZ stock. As the broker buys the stock the price starts to rise. Ecstatic and emboldened by his/her "wisdom," client says lets buy some more. Same outcome as the stock again rises. To cut to the punch line, the client repeats the process and the stock continues to miraculously rise until the client decides that's enough. So, client calls the broker and says, "sell." You already know the response, right? "Sell to who? You were the buyer." Baby boomers and broader US households take heed.
Although it has been quite some time since I have checked in on the character of US payroll employment, it's high time for a highlights only review right now. Why? Given that we are living in a period of equity market and residential real estate price reconciliation, lack of continual household asset inflation of the moment is a drag of sorts on consumer emotional and financial well-being. That leaves the character of the labor market as being quite important to the consumer psyche absent a meaningful resurgence in near term asset inflation. As per 4Q 2007 household experience, household net worth declined for the period driven by both real estate and equity value contraction. Again, at least in my mind, payrolls are front and center in this environment as probably the most important bottom card in the total consumer house of cards. Payrolls will be the arbiter at the margin of the ability of consumers to do what they do best - consume. Let's get right to it.
Although monthly payroll numbers are notoriously susceptible to short term revisions, February of this year gave us the second down month in a row for payroll employment numbers. One has to travel back to the middle of 2003 to find a similar occurrence of back-to-back monthly declines in US payrolls. It's simply not something that happens very often. And as you may remember, this was the exact time US payrolls actually started growing once again after a lengthy multi-year contraction that started as 2001 dawned and carried through to mid-year 2003. It's all laid out in the following chart.
What this tells us is the likelihood of actual recession is growing. Let's start a very quick review with the first generic chart that is the four-decade history of the year over year change in US payrolls. What's so important about this? Every single time we've come down to the level we currently see, the US economy has ended up in recession. We've never over this entire period been down to this annual rate of change level without going into rate of change contraction mode as per the US labor markets. Lastly, as is more than clear, we currently rest well below the mid-cycle economic slowdown experience of the mid-1980's and mid-1990's. The fantasy of a mid-cycle US economic slowdown occurring in the current cycle is yesterday's news according to payroll rhythm of the here and now.
On to two more very important macro payroll character indicators - temp employment and retail sales employment numbers. As I've drilled into your heads far too many times in past discussions, temp employment leads headline payroll employment. Case closed. You can see exactly what I'm referring to in the following chart. As of February, we have a new cycle low at a 4% year over year decline in temp payrolls. The headline trend is following in virtual lockstep with the contraction in temp employment. Until temp trends turn up, headline payrolls will continue to decline on an annual rate of change basis. Temp payrolls are tugging on the bottom card, so to speak.
You may remember that I've also imparted to you in the past that retail employment trends are a coincident indicator for headline payroll numbers, in a bit less precision than temp employment leads. Directional similarity continues to play out as we speak. At major lows of the past, the rate of change in headline payroll employment has bottomed prior to retail employment trends, but the retail trends have corroborated important directional change in the headline numbers for each cycle turn, and that's what's important. For now and until proven otherwise, payroll trends are down. No turn and no corroboration.
Is the deterioration in US payrolls some big surprise? Far from it. In fact, these very indicators seen above predicted this long ago, as they continue to shed light on just where we are moving ahead. I detailed all of this in a discussion last August entitled, "Just Roll With It".
I'll leave you with one last chart that reinforces the point about the rhythm and character of US payroll employment being quite the important issue for consumption trends in a period becoming increasingly absent of household asset inflation. What we're looking at below is the year over year rate of change in non-auto and gasoline retail sales (the black bars) alongside the year over year change in US payroll employment. The directional similarity here is self-evident.
You already know I could go on and on with this analysis, but we'll stop right here. According to the playbook of historical precedent, it sure as heck appears as though US payroll trends will continue to deteriorate ahead. And that's not a good thing for US households no longer basking in the glow of household asset inflation. We need to remember that when equity values turned down in 2000-2002, and this was clearly reflected in the contracting value of household equity holdings, residential real estate values continued to venture ever northward supporting total household net worth stability and ultimately growth. But not this time. At least as per 4Q numbers and looking over the entirety of 2007, the two largest household assets that are equities and residential real estate declined. Although we have not yet closed the book on the first quarter of this year, it's clear household real estate values will continue to contract on household balance sheets. Equities should do the same, barring some miraculous 11th hour quarter end save. Is it any wonder the Fed announced the $200B TSLF literally prior to the open on the day after a number of major equity indices were sitting very, very close to their lows of the current year? It's no mystery at all.
Until households are once again reveling in the equity and residential real estate asset inflation they have grown to know and love, the bottom card holding the greater "house" upright is payroll employment. At least for now, this bottom card isn't exactly resting on bedrock foundational support, now is it? But have no fear, US households are not about to dump their equity and real estate holdings. After all, sell to who? They were the buyers.
© 2008 Brian Pretti