Our Spirits Cry Out For Water
by Brian Pretti CFA, Contrary Investor. May 23, 2008
Critical to US households ahead, in my mind, is liquidity. Just as this issue is now life or death for the commercial and investment banks. Although the Street appears myopically focused on this very issue when it comes to the Fed, the US financial system and its key players, they should be equally as focused on US households when it comes to the question of liquidity. Yes, the very households that have made the quarter century US credit cycle literally hum, until recently. So let's have a look at household liquidity circumstances of the moment. You already know, a lot of charts to come that in very good measure tell their own story quite simply and elegantly.
First a very important reminder. Liquidity, or cash, in the charts below is comprised of all cash, bank deposits, CD's, money funds and all bond holdings (Treasury, agency, corporate and muni) of these very same households. I try to be as generous and all inclusive as possible with the definition of household liquidity. Narrow it is not. About the only things not included in the definition of liquidity, or cash, in the charts that follow are household ownership of real estate, equity holdings (including pensions) and private business equity. Otherwise I'm pretty much throwing the kitchen sink into the mix of so-called liquidity just to give households a big benefit of the doubt. Onward.
First up is a repeat of a chart I have shown you in the past. Very simply, household liquidity relative to total household liabilities as of year end 2007. Have a look.
Sure, you can suggest that this is not measuring liquidity means against asset values. Sure, you can suggest that households can sell their assets and raise liquidity literally any time, right? As you know, that's working out so well in the residential real estate market right now. Or perhaps in the personal holdings of auction rate securities brokers have done such a good job of equating to money funds and "selling" to the public, until the market literally froze up recently leaving brokerage clients stunned that they can't get their money out of what were sold to them as money fund equivalents. You get the picture. To suggest assets are always and everywhere marketable is just a bit foolhardy. Don't believe us? Just ask former Bear Stearns employees how that works, okay? They probably have a few insights. Yes, in terms of this measure as defined in the chart above, we are barely off of 55-year lows. Do you think households are unaware of this? I suggest they have gained a whole new insight in recent years, and perhaps especially since last summer.
Another very simple manner of looking at this same relationship is to subtract household cash (liquidity) from those very same liabilities. And what do we get? Wonder no more.
Let's just say that decade to date experience is just a tiny bit different than the prior five decades. After all, it sounds so much better that way, wouldn't you agree? And here investors are currently fretting over a potential $1 trillion write off of bad financial system credits. Pish posh! That doesn't hold a candle to the $3 trillion hole US households have dug for themselves in their current liquidity position relative to household liabilities. Seems US households could teach the US financial system a thing or two about risk taking and leverage layering, no? Those financial sector lightweights.
When the going gets tough in the US economy, the tough go shopping. Don't they? At least that's been the modus operandi of US households for some time now. Below is a picture of the resilient US consumer at work. Hmmm. Seems there's been a bit of an acceleration in this little measure since the boomers came of age in the early 1980's and started receiving at least five credit card and mortgage solicitation offers in the mail each and every day. Of course the real angle of ascent was saved for the current decade. C'mon, nothing a bailout or two can’tfix to help get households moving back on the road north in terms of liability expansion relative to income, right?
I won't belabor the point as I have discussed this many a time in the past, but I'm convinced that over the last few decades, increasingly the conceptual lines between real liquidity means and access to credit availability for US households has blurred. The equity line of credit has become thought of more as access to cash as opposed to what it truly represents – access to debt. We've often heard the term "cash-out" refi's. Shouldn't that really be debt-out refis? You get the point. It's only when asset cycles turn down, as is now the case with US real estate and in good part US equities, that the true nature of liquidity stripped of the conceptual relationship to further credit availability begins to become a bit more clear. As the ability of debt driven monetization of household asset values begins to subside, the true character of liquidity means reveals itself.
So as we look ahead and consider the financial/liquidity circumstances of US households, and ponder the trajectory of the true US and global economy post the financial market relief interlude of the moment, we need to address the question, will the current character of household liquidity lend itself to broader credit market and real world economic healing? Yes or no? Or maybe more importantly, will US households feel the need to increase their balance sheet liquidity circumstances in what has been a recent deflationary environment for their two largest asset holdings - residential real estate and common stocks? I suggest this question especially applies to the boomer generation who is necessarily going to need real liquidity in retirement years. Certainly a lot depends on employment circumstances ahead for the near retirement boomers as the real US economy continues to deal with macro credit cycle reconciliation issues near term.
People Never Planned Here For Water
This question of households and their liquidity circumstances at any point in time is quite the important issue for financial market outcomes ahead. Over the years you've seen the deterioration in the reported US savings rate numbers. A data series that has been quite the object of criticism decade to date in that no credit in that calculation is given to rising real estate values as a theoretical method of savings. Certainly that particular criticism has died down as of late, and for very good reason. I'll spare you a long term chart of the US savings rate as I'm pretty sure you've seen it many a time. Rather, let's drill down a bit decade by decade and have a look at the US savings rate relative to equity market outcomes. After all, I believe the linkage is direct and meaningful.
First, savings vis-à-vis liquidity growth, per se, and potential investment in equities is an alternative choice for households. Save in cash, bank products or bonds, or invest in equities as a means of savings. The tradeoff is simple. To be inclusive, real estate is also an investment choice, one not wildly popular for now. Moreover, savings versus consumption likewise relates to the savings versus equity tradeoff as consumption theoretically lifts corporate earnings, and in turn equity values. Let's have a look back at the very simple relationship between the US savings rate and the performance of the S&P 500 as representing equities over time. We're largely covering the 1980 to present period. In other words, the coming of age and maturation of the very boomer generation that holds the key in large part to forward real world economic and financial market outcomes.
As we look at the 1980 through mid decade relationship, it's clear that the equity market saw its best days while the official US saving rate experienced periods of meaningful cyclical declines.
Moving on to the 1987 period through the end of the last decade, this is what we find. As you can clearly see, it is when the savings rate really started to drop from the 8-9% level all the way down to roughly 2% that the equity market really took off.
Finishing up with the decade to date period, again we see the consistency of elongated periods of decline in the official savings rate aligning with the most meaningful period of equity market gains.
So there you have it. I believe the message here is extremely consistent across the last near three-decade period. Remember, the exact period of baby boomer coming of age into maturation. And that important message is, the equity markets put on their best face when the US savings rate is experiencing interludes of meaningful decline. Again, as stated at the outset of this discussion, this is virtually a common sensical truism. The alternative choices relative to savings are consumption and/or investment. This is simply economics 101 in its most basic form. Quite simply borne out in the relationships depicted in the three charts above.
So as we look ahead, THE big question becomes, will US households act to increase their liquidity (savings) circumstances? If so, there certainly will be a tradeoff somewhere in the savings versus consumption or investment alternative choices. Point blank, history tells us that equities have fared best in declining aggregate savings rate environments. At a recent reading of 0.3%, just how much lower is the US savings rate going from here? Again, more importantly, the real issue is forward household choices regarding increasing liquidity (savings) that will indeed have a real bearing on financial market and economic outcomes. While investors are currently worried about financial sector liquidity, I remind you to please remain focused on household liquidity circumstances as being at least equal to, if not greater in importance than financial sector character. Yes, the powers that be can influence financial sector outcomes. But just what can they do to influence the liquidity circumstances of US households? To be honest, to support both the financial markets and the economy, the powers that be are going to have to discourage increasing household liquidity, exactly as the have been doing for far too long now. In our minds, the character of household liquidity is one of THE key macro investment issues of the moment.
© 2008 Brian Pretti