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October 01, 2001

The Accelerant

Backdraft...In our September discussion, we questioned whether the US consumer would be able to continue along the consumption path in support of the economy in relatively undeterred fashion ahead. Little did we know at the time that the horrifically tragic events of September 11 would be right around the corner. We have seen many a pundit point to the World Trade Center incident as being the cause for an economic downturn to come. We have witnessed many a corporate press release anticipate a diminishment in future results claimed as directly related to the WTC horror. In our minds, the fallout from the terrorist attacks are not a cause at all, but rather an economic accelerant in the deceleration that began at least nine to twelve months ago.

The US consumer has been witness to deteriorating stock prices for 18 months now. The 2Q 2001 Fed Flow of Funds report released in September records the ongoing year over year contraction in consumer net worth:

Most assuredly with stock market action in 3Q, these numbers have gotten a lot worse. In addition to the psychological effect of the financial markets, weekly unemployment claims and layoff announcements have been dripping slow but steady black rain on consumer spirits for the better part of the year.

Certainly, the results of this tabulation spike higher in the months ahead given the near term impact of the economic reality seen in the air travel and related tourism industries. Additionally, the weight of increased leveraging of consumer balance sheets grown over years of excess consumption in coincidence with a general decline in cash savings has been slowing the consumer more rapidly in recent quarters. The psychological fallout of the WTC incident accelerates the process downward.

As you know, the WTC tragedy is an immediate shock to the system. An instantaneous stress point where there was none but a few days prior. A negative shock that heightens emotional consumer response to future stock price movements, economic reports and potential acts of war. Unlike many exogenous shocks of the past that have jolted the stability of the US consumer/investor, this event comes at a time when both macro economic reality and the general perception of that reality are already fragile. Making it especially difficult for the domestic consumer to stay on his or her feet. We only have to look back a little over ten short years ago to witness the results of the external shock of Iraq invading Kuwait:

Although much of the current consumer confidence report was completed prior to the Sept. 11 destruction, it seems we are now and will continue to be watching a replay of a consumer confidence reaction to an unanticipated event that is immediate and sharp. Moreover, the Iraqi invasion of Kuwait was geographically definable and offered a specific cast of human characters upon which to focus. The current circumstances offer no such contextual certainty. As you can see in the above chart, in each and every recession of the last 30 years, consumer confidence made a pit stop below the 60 level. At a current 97.6, it's still a long way down from here. What are the chances of seeing that level or lower during this cycle? Pretty darn good given that the accelerant is now in place.

The Comeback Kid?...It's clearly no secret that corporate capital spending has been in a recession, if not a modern day depression, for the last twelve months at least. The WTC tragedy appears to be the psychological depressant that accelerates an already downward rate of change environment for the consumer in terms of credit growth and spending:

Economic statistics released in the last few weeks that largely cover the period prior to September 11 have shown renewed downward economic momentum in the late summer. It's certainly no huge leap of faith to suggest the numbers get worse ahead. Possibly a whole lot worse. As the bear market matures, the second act of what so far must still be characterized as a cyclical phenomenon will be played out ahead as the consumer buckles. For our money, economic and financial market analysis now moves on to the questions of depth and duration. Just how deep will the current recession become and for how long will it last? Although unknowable in advance, we would hope that an examination of current contextual backdrop as well as the anecdotal evidence of history will allow us to remain rational and objective in decision making ahead. From a contrarian standpoint, it's good to see certain negative sentiment mount. But negative sentiment alone will not mark any kind of financial or economic bottom. Historical economic signposts of distress will be important markers ahead. A consumer confidence number below 60, for example, will at least demand thought and potential reassessment. We'll take it one step at a time.

Set Design... In trying to make sense of the economic and financial drama that is to unfold ahead, it's instructive to be aware of the backdrop against which the story will be told. Protagonists and antagonists in the cast of players are many. It just so happens that the Fed Flow of Funds report released a few short weeks ago is nothing short of a wealth of information regarding the current theatrical set design. For the corporate and consumer sector, it may not be the most opportune of times to be facing a domestic and global economic slowdown. The credit excesses introduced into the system over the last few decades will definitely be a hangover from which the corporate and consumer sector will have a tough time recovering in trying to spark economic growth ahead. The following are perspectives taken directly from the numbers found in the Fed report:

Although it can be argued that interest costs today are lower than in recent cycles of the last two decades, absolute dollar corporate debt relative to the benchmark of GDP is as high today as at any time in recent history.

In like manner, relative to meaningful benchmarks, household debt is well above past experience:

Finally, financial sector debt relative to non-financial credit obligations (government, household and non-financial corporate) is at all time highs.

At the very least, leverage in the current system suggests that the character of an ultimate economic recovery may be much more muted than many of the "V" experiences of the last three or four recessionary interludes. The stage is set in rather somber tones.

Of Hangovers And Overhangs...In addition to the credit hangover being a potential impediment to an ultimate economic recovery growth rate, for the financial markets the question may not be one of hangover, but rather overhang. It is most telling in the recent consumer confidence reports that the over age 55 crowd has been the most pessimistic. You remember, the folks set to retire dead ahead. With approximately $6-7 trillion in stock market value having been wiped away over the past 18 months, it's no wonder this demographic is a bit shaky. As you may know, according to AMG data, there has been very little in the way of equity mutual fund redemptions as of late. About $11 billion over the period three days prior to WTC until almost month end. Although the media touts this as significant, compared to what has been put into funds over the last decade and the current market cap of equities, it isn't even a rounding error. Technical indicators such as put/call, TRIN, VIX, ARMS, etc. may suggest capitulative activity, but absolute dollar redemptions suggest something much different. Whether the public becomes involved in wholesale selling at some point remains an open question. What is not in question is that asset allocation to equities among many market sector participants is still very near historical highs. Once again, thanks to the Fed for doing the numbers for us:

Just as leverage in the system is a clear concern for the economy ahead, asset allocation must be given attention in terms of what an ultimate economic recovery may mean for buyers of financial assets. From a very simplistic standpoint, we are very near all time high investment allocations to equities for both households and institutions. Surely foreign allocation is also much closer to the top end of the historical range. This suggests that corporate earnings growth will be much more important to future stock prices than it may have been over the past decade. During the 1990's, the market had earnings growth andasset allocation as the twin afterburners of stock price levitation. It sure seems the macro asset allocation transition is all but complete at this point.

Sugar Keynes...The WTC incident as being the accelerant applies not only to the near term acceleration of the economic downturn for this cycle, but also to what will be accelerated fiscal spending and monetary accommodation on the part of the government and the central bank ahead. Clearly the Fed has been fighting the economic deceleration battle with interest rate policy and open market operations for nine months now to little or no avail. But it seems obviously apparent that fiscal spending is set to kick into high gear. The Keynesian solution, if you will.

We have heard zero talk of "saving social security" in the last few weeks. We expect the government to have checkbook open and ready for spending in the period ahead. And not just for the military effort. To allow the economy to sink rapidly from here raises the risk of serious deflation possibilities. Perhaps the unthinkable. As you know, cold war deficit spending in this country mushroomed in the 1980's in an effort to vanquish a global threat that was largely conceptual in nature. There was no open conflict and no violence on American soil. Just what do you think the possibilities for deficit spending are when innocent US lives have been lost and the perception of future risk has grown substantially?

As a last comment for this month, what should amount to the deflationary pressure of a slowing US consumer on both the domestic and global economies will be met with what seems the only alternative of supercharged fiscal and monetary policy. It also seems a sure bet that the global central bank powers that be will also step on the gas ahead. We believe it's a fair statement that near term forward GDP will be increasingly dependent on government spending. The waters between the Scylla and Charybdis of reflationary and deflationary pressures have grown more murky over the past month. Although we are not ready to pass judgment quite yet on the eventual outcome, there is no doubt that the rocks and whirlpool on either side of the passage are just as lethal, and navigating the narrow strait has grown more dangerous. We expect the government to put up one hell of a fiscal policy fight in trying to support the economy directly ahead.

What does this mean for bonds? Although the jury is still out, the following are perspective:

It is interesting to note that August recorded a record $16.5 billion net inflow into bond mutual funds. Are investors arriving late to the bond party? From a long term perspective it sure appears as much. Unless the world is truly coming to an end ahead, it sure seems there is very little to be gained in short maturity Treasury paper outside of capital preservation and stated coupon. Although this certainly will not happen overnight, will the WTC incident and its influence on accelerated monetary and fiscal accommodation sow the seeds of future inflationary pressures? If nothing else, it's a question we certainly intend to monitor and address ahead.

Although we are often amused at the historical repetition of human decision making in the financial markets, we continue to be personally shocked at the human decision making involved in man's inhumanity to man since day one on this planet. Our deepest sympathies go out to all who have been touched by the tragic events of September 11. Our best to you and your families.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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