by Brian Pretti CFA, Contrary Investor. January 16, 2009
The fact that the December retail sales report this week was bad was not exactly a revelation from the heavens by any means. But I think the issue takes on larger meaning in terms of the ongoing battle of trying to decipher what the financial markets have and have not discounted in price at any time. A battle that’s not about to end any time soon. As I’ve written about on my subscriber site, the drop in the equity averages over the past year plus are very much on par with the death defying drop in equities during the mid-1970’s, in coincidence with what was a very deep recession at that time. As such, I’ve been counseling folks that it seems a good bet the equity markets have already discounted a deep recession. Personally, I'm now using economic and market stat markers of the mid-1970’s and early 1980’s recessions (the deepest post Depression US recessions) to benchmark against our current circumstances. The questions that remain to be answered in the current cycle are magnitude and duration of economic contraction. These are the key issues, if you ask me, against which we can ultimately judge what the markets have or have not discounted in price.
In conjunction with this analysis that we will continue walking through for some time to come, the other major issue of importance to investment decision making will be the character of the deleveraging cycle that clearly has begun. In short, it does not take a rocket scientist to know that deleveraging in the financial sector is more than well underway. But actual deleveraging in the household and non-financial corporate sectors is in its infancy. Given my personal belief that the prior credit cycle was massively important in determining corporate earnings outcomes, asset price inflation trends, etc. over the prior three to four decades, monitoring the reality and specifics of the now begun multi-sector (financial, household, and non-financial corporate) deleveraging cycle takes on very meaningful importance. Again, it’s going to be a matter of magnitude, duration and breadth of sector deleveraging that will impact investment outcomes in the here and now.
Without sounding overly simplistic, investment outcomes in 2009 and beyond will hinge on magnitude and duration of both the necessarily intertwined economic and deleveraging cycles simultaneously presenting themselves to us. Chart the risk management course well, maintain ongoing knowledge of the facts, and being observant about how the markets react to ongoing news about each of these concurrent cycles will be the keys to investment success, or otherwise. Simple, right? Yeah, sure it is.
In looking at the retail report, I simply hope to give you a little insight into our thought process. Right to the point, the headline numbers looked terrible. But the real eye-opener is the historical year over year rate of change in headline retail sales. Get the picture?
Wow, now there’s something you don’t see every day, no? That’s right, no. A few quick observations. First, we all should know that recent month numbers have been quite negatively affected by what can only be characterized as implosions in nominal dollar auto and gasoline sales. No mystery. BUT, the 60 years of data you see above also include auto and gasoline sales from start to finish, so it’s a little too “convenient” to dismiss the magnitude of the drop based on these two factors alone.
Second observation is that virtually every time we’ve seen a rate of change spike down in annual retail sales growth historically of even near current magnitude, it has been followed in short order by a pretty darn meaningful rate of change spike right back up. Let’s face it, this should indeed occur as it’s hard to imagine auto and gas sales falling ahead at a magnitude we’ve seen over the last three to four months. The questions to be answered directly in the months ahead will be magnitude and duration of downturn, and the influence of household deleveraging on the potential for rate of change recovery.
The magnitude and duration part of the equation is pretty simple stuff. We simply watch the rate of change data in the chart such as above and in many other economic stats. But what about the household deleveraging issue? On my site I continually track what I refer to more as core retail sales than not. That’s headline retail numbers less auto and gas sales. And just what does that look like? Wonder no more.
At least since the last recession, we’ve never seen a dip in core retail sales fall into negative territory. The last time this happened was in the early 1990’s. Unfortunately, I believe this now very apparent trend is not about to change anytime soon. Why? Well, all one had to do was have a little peek at the most recent payroll employment reports over the last three months or so to know labor and wages are and will most likely remain under pressure for a good while yet. Retail may have been a bit immune to payroll cycles decade to date as clearly credit availability and cost of credit was the plug factor at any point in time for households. But that’s over for now. And increasingly over for households.
But as we look ahead, I’d suggest perhaps one of these biggest issues central to incorporate into our decision-making and that will without question influence forward retail trends is the potential for household deleveraging. Will this influence magnitude and duration of our macro economic circumstances? You bet. The following chart shows the quarter over quarter growth in household leverage dating back to 1960. At this point, no one should be shocked at the long-term trend. From households increasing leverage in the $200-300 billion range quarterly just a year or so back, as of 3Q 2008, the number for the quarter was $14 billion of growth in household debt. Let’s face it folks, this ain’t gonna do it in terms of charting a course for a recovering consumption driven US economy. Quite the opposite. This is a picture of households that have dramatically reduced their leverage acceptance over the prior year. But, as is suggested in the chart, it is not yet a picture of true deleveraging – actually paying down debt. My personal bet is that we will see the true beginnings when 4Q data is released in the months ahead.
For a preview of delevraging, take a peek at the last consumer credit report. BOTH revolving and non-revolving credit balances fell. That’s a big rarity and is the true picture of deleveraging. Certainly a few months of data do not make a trend, but the picture above is not reversion to the mean, it’s implosion to and through the mean, so to speak.
As I’ve argued until I’m blue in the face over the years, headline economic stats mean very little to me. It’s the components that make up these headline numbers that are so important to analyze, hope to understand and interpret. The components of economic statistics tell the real story, especially set against historical precedent. And I’d suggest probably now more than at any time this decade, truly seeing what is happening and being very aware of the character of the economy will allow us to both benchmark against prior cycles and get a feeling for what the markets are discounting at any time in terms of magnitude and duration of the current economic slowdown. If we can get the economic reality versus what the market appears to be discounting analysis correct, then we can hope to “see” potential bear market rallies from a true equity market cyclical turn. That may indeed be one of our most important challenges for 2009. For now, the tempo and tone of retail sales is as bad as anything we’ve seen in six decades. For now, the US consumer is walking directly onto the path of a true deleveraging experience I believe lies dead ahead. Has the market completely discounted these facts and emerging trends?
One last issue is that it’s not just retail numbers that look awful right now set against historical character. We’ve been keeping a running benchmark tally and analysis of important indicators in our discussions in the hopes of staying on the right side of market volatility and trying to interpret whether what the markets appear to be discounting at any point in time is correct or otherwise. Although this may sound like a very conservative statement, in the current cycle we need follow up economic corroboration to directional market movement, not speculative guessing. The stakes are too high. The extremes in economic stats we are seeing right now will indeed prompt what we believe to be an even more extreme response from the Fed/Treasury/Administration. In simple terms this will be the yin and yang of the financial markets in 2009. The reality of all aspects of long term credit cycle reconciliation, of which retail is simply one component, set against the extraordinary, extreme and go for broke monetary and fiscal response already in process and far from exhausted.
© 2009 Brian Pretti