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September 07, 2002

Unfinished Business

Consumption Junction?...Although the recent official headline recession is over for now, current labor market conditions resemble anything but a strong economic recovery. Important in that households have stretched financially over the last few years to continue spending. In good part responding to stimulus such as low mortgage rates and zero percent auto financing. But for how much longer can consumer spending hold up as labor market conditions remain stuck in limbo, not getter a whole lot worse, but certainly not improving meaningfully at the margin? Although we have begun to deflate the bubble in the equity markets, the bubble of systemic leverage expansion has barely been addressed. Households have continued to lever as if there has been no downturn at all. As we approach the anniversary of zero percent auto financing schemes and current mortgage rates bounce near multi decade lows, for how much longer will anomalistic financial incentives support consumer spending via further leveraging of personal balance sheets as labor markets now approach conclusion of their second year of historically relevant weakness? Certainly the answers to these questions lie ahead and will have direct bearing on the economy as a whole, but anecdotes are beginning to mount that suggest change in consumption patterns at the margin are beginning to emerge.

There was asset price "cheering" on Wall Street with the release of the recent unemployment report. The headline revealed that the unemployment rate dropped from 5.9% in July to 5.7% in August. But as usual, a peek behind the headline reveals a bit less to cheer about. It just so happens that on a net basis, private sector (non-governmental) job creation was actually negative. It's the first time this has happened since April of this year. The headline employment number read an increase of 39,000 gainfully employed bodies for the month, but the increase in government workers was 41,000. And of the government body count increase, close to one half were airport security workers. Suffice it to say that the report was actually nothing to cheer about in terms of the private sector. It's not just the employment report where tepid labor conditions are characterized. Broad economic statistics are littered with anecdotal evidence. Jobless claims data is clearly starting to resemble the jobless recovery period of the early 1990's:

The help wanted index at the moment rests at a low not seen since August of 1964. Corroborating jobless claims trends is the fact that the help wanted reading has been meandering in the mid 40's area since last October. Most post recessionary experiences past witnessed a "V" shaped recovery in this reading. The only two periods of the last four decades to experience lingering weakness in help wanted readings was the early 1990's and now:

The Institute of Supply Management (the ISM - formerly the National Association of Purchasing Managers) index for both the manufacturing and non-manufacturing sectors of the economy has continually suggested a malaise in labor conditions over the past few years. Just for drill, the ISM readings are what are called diffusion indices. Academically, a reading above 50 represents expansion and a reading below 50 represents contraction. Without going into lengthy detail, we consider anything above 48 expansion. This is what employment conditions have looked like in both of these readings over the recent past:

Although employment conditions have improved on a relative basis compared with post 9/11 experience, modest contraction remains the characterization of the moment.

Lastly, the recent Challenger, Gray and Christmas layoff count spiked anew this month with the current reading standing well above any experience of the 1990's.

We're not suggesting that the world is about to come to an end for labor markets, but rather that these markets are stuck in limbo for now. Stuck in a netherworld of neither significant deterioration nor recuperation. Perhaps the most ironic implication for the financial markets over the near term is that these tepid statistics just may not give the Fed enough justification to ease interest rates near term. Despite an equity market that may be terribly desirous of such a perceptual event. In like manner, labor markets have remained difficult for a long enough period that consumers may be set to change their forward spending habits at the margin.

As we will cover ahead in this discussion, equity mutual fund holders continued to "consume" equity mutual funds well after the top in the major equity indices had already been seen. In denial that a severe downturn in equity prices could be a possibility, let alone a strong probability. It has been only recently that the face of equity mutual fund consumption appears to be changing in a meaningful fashion. In the face of clearly tepid labor market conditions at best over the last few years and now a relapse in macro economic weakness, American households have continued to lever and spend as if a significant economic recovery were right around the corner. Are we set to move from the denial to the realization phase of the consumer spending cycle ahead much as appears to have happened with equity fund participants?

Retails From The Crypt...Despite the apparent economic recovery starting late last year, the complexion of retail sales have started to change a bit. Ex the volatile auto and gasoline components of the report, retails sales year to date have been nothing to write home about:

There is no question that autos and housing have really carried the ball in terms of being key economic supports over the past few years. But time is running out on each in terms of acceleration in per unit growth rates. Any semblance of pent up demand in both sectors has surely been satiated in large part over the last few years. As we move forward, financing incentives will have a diminishing impact on growth rates. Very possibly, consumers will again begin to accelerate spending in the non auto and housing portion of the total retail sector, but recent evidence suggests something to the contrary. Significant sales and earnings disappointments have recently been seen at such key retailers as Best Buy, Circuit City, and Radio Shack. Just this week, Wal-Mart announced that recent sales are falling below plan. Home Depot made their recent quarterly numbers purely on the back of cost cutting as declining S,G&A offset 4.2% same store sales declines. And something else very interesting appears to be happening with very little mainstream notice.

In the following chart, we simplistically present the historical growth rate in personal consumption expenditures less the growth rate in average hourly earnings. Have a look:

Again, on a very simplistic basis, what you are looking at is the matching of the growth rate in personal spending with the growth rate in wages. Very few times in the last forty years has this relationship dipped this low. Although historically this relationship contracts in recessionary periods exactly as one would expect, it also expands rather violently in emerging economic recoveries. Emergence as post recessionary pent up demand begins to be felt. For now, this reemergence is non-existent.

Suffice it to say that there are anecdotal signs emerging that consumers are beginning to realize that strong labor market and economic recovery is not right around the corner. Unsustainable and perhaps dangerous financial incentives reign the day. We have yet to feel the eventual backlash of allowing folks to waltz out the front door with new autos having put zero cash against the purchase. Ford Motor Credit and GMAC have bought into the concept of the sustainable consumer credit cycle very late in the game. Their stock prices have reflected such. The recent real estate refi boom may yet support another burst of consumer spending strength ahead, but from a secular interest rate cycle standpoint, we are certainly approaching one of the last major residential refi cycles of perhaps the next decade or longer. The two decade bull market in the ability to near continuously refinance many forms of debt is drawing to a dramatic close. Have we reached the point where in the absence of relatively extraordinary and unsustainable credit stimulus, the economy is flat at best? Are we approaching the point when consumer America addresses the fact that the labor markets are not turning around in earnest as their spending habits continue as if recovery has already happened? The evidence is mounting. Evidence critically important in light of the following historical relationship of personal consumption expenditures to GDP:

Unfinished Business?...Certainly we are witnessing bubble deflation in the equity markets. After one of the most incredible equity bull markets in our financial history, set against the backdrop of possibly the greatest credit boom this country has ever seen, a period of significant reconciliation is only to be expected. Where are we in the process? In terms of the equity markets, it's really anyone's guess. Aggregate valuations have compressed, but the bubble that still remains completely unreconciled at the moment is that of systemic leverage. In our minds, the two are inextricably linked, as is the influence of this combined reconciliation on the real economy. Let's have a brief look at macro equity market valuations of the moment. Remember, although this may sound contrite, it's really a market of stocks and not stock market. We present these charts for context as opposed to making a statement that equities in general should be avoided. That's far from the case.

Let's be realistic, measuring the aggregate markets or specific indices such as the S&P 500 based on earnings is fraught with risk. Yes, there are many companies with no earnings that can skew the current numbers higher. Yes, earnings are depressed during this time of economic softness. Academically, although the argument that one should expect relatively high earnings multiples during an earnings trough is intuitively appealing, we are going to need to see significant earnings expansion ahead to justify current earnings based valuations. Hence, to attempt to get beyond the issue of cyclicality a bit, we prefer to look at historical price to sales measures.

Nothing says that we have to return to the depths seen in the 1970's and early 1980's for equities to be considered attractive, but as you can see, we are currently nowhere even near the average of this ratio over the last half century (red dotted line). The wings of Icarus have begun to melt in the hot sun, but the taste of salt water lies far below.

We would caution that the following price to dividends ratio has been dramatically skewed during the "new era". The stock option compensation schemes so popularized during the 1990's provided a huge disincentive to pay out precious corporate cash as opposed to the supposed tax efficiency of buying in shares. It's really no mystery as to why this ratio rose to literally unprecedented heights:

What remains to be reconciled ahead may just be the very mathematical nature of historical equity returns versus current expectations. We have witnessed many an institutional pension plan sponsor significantly reweight portfolios over the last few months in favor of increasing equities and decreasing bond exposure. A reweighting based on the assumption that equities have provided superior historical returns relative to fixed income products. An assumption that future returns will resemble past experience. The potential significant mistake in this set of assumptions being that dividends have historically played a very meaningful role as a component of total equity return. Dividends that today are near the lowest levels ever witnessed. Implicitly, to earn what has been the average annual return for stocks over the last century in the years ahead, price will need to play a much more significant role than will dividends as the current price to dividends ratio clearly reflects. Is this really realistic?

Of all of the aggregate measures of equity market valuation that indeed suggest the equity bubble is being addressed and corrected, price to cash flow is possibly the most convincing.

Although still above much of historical normalcy, it is falling to earth with possibly the greatest of gravitational pull. But as you know, this comes with a price. That price is the labor situation depicted in the first part of this discussion and the fact that corporate capital spending barely measures at the moment on the Richter scale of financial life.

Although considered a "has been" measure of equity valuation, price to book value remains literally off the charts.

Although we would agree that this measure must be put into context in terms of the significant service portion of our economy (less asset dependent) and the fact that write-offs have skewed the measure heavily, especially over the last decade, we would point out that in this current period of emerging corporate credit reconciliation, hard assets take on heightened meaning. In a nightmare scenario for corporate lenders, this is collateral, or lack thereof. Certainly our friends at Enron or Worldcom just didn't have enough of this when the you-know-what hit the fan, now did they?

One of our favorite benchmarks of relative macro equity market attractiveness is market capitalization to GDP. Elegant in its simplicity. And consistent over time. Book value may be irrelevant, dividends may be a moot point, but GDP will never be irrelevant nor moot set against the context of the value of corporate America at any point in time as being able to produce a certain level of GDP. Simply enough, the chart says it all:

These charts are telling us that the equity bubble is surely in the process of reconciliation. But, ultimate bottoms are a guessing game at best. We can look back at periods such as the early 1960's where inflation and interest rates levels were quite similar to what we experience at the present. The market bottomed at valuation levels much higher than was seen in the 1970's or 1980's bear bottoming episodes. But what clearly stands out to us as a key differential in our present circumstance relative to almost any other period of the last century is leverage. For now, it is the bubble that has kept right on expanding as the equity valuation bubble has begun to contract. It is the bubble that may ultimately have a much more direct impact on the real economy if this period of domestic economic malaise is prolonged in nature. It just may be the most important unfinished business relative to this in process equity bear market.

For now, we will leave you with just a few glimpses of historical context. These charts are as of 1Q 2002. We expect new Fed data within a week or so to update through 2Q. The following charts do not suggest that the world is about to come to an end, but rather that we exit the current recessionary period with the smallest aggregate degree of financial flexibility this country has seen in 50 years at least. The following are financial weights shackled to our ankles. Preventing us from an economic sprint so characteristic of emerging economic recoveries during the post war era to date.

Virtually completely uncharacteristic of recessions past, consumer credit has rocketed skyward throughout the official recession and beyond. As you know, there may be no interest on the car loan, but no one said anything about the significant principal repayment bill being a piece of cake:

Academically, we must remember that the household ownership rate in the US at present is pushing near 70%. A record number. Having said that, growth in mortgage debt has certainly outstripped the growth in homeownership rates over this period.

There is no law that suggests financial bubbles must be reconciled in simultaneous fashion. During the latter 1990's, Fed induced liquidity was sufficient to support both equity market valuations and the real economy vis-à-vis credit expansion. For now, that is no longer true for the equity markets. Although it still may be true in part for the real economy, systemic leverage expansion is "buying" lesser and lesser amounts of GDP growth as we move forward. Anecdotes of the law of diminishing returns lie at our feet. There is unfinished business in bubble reconciliation for this cycle.

Flow Motion...By now, it's certainly common knowledge that we saw the largest single month for equity mutual fund redemptions in the history of the US financial markets during July. A bit of a milestone. The official ICI (Investment Company Institute) compendium put the outflow at $49 billion in July. But what was perhaps the most interesting aspect of these recent numbers is the fact that it is estimated that equity mutual fund managers only sold $36 billion of equities in July as cash as a percentage of equity mutual fund assets dropped to 4.3%:

As you can see, as of July month end, cash in equity mutual fund rests near a three decade low. Nowhere even near the levels of cash seen at sustainable secular equity lows. As you know, in the modern investment era, many a fund family has either an actual or unofficial mandate to remain near fully invested at all times. But is this really serving the best interests of their broad fund clientele? Or just serving the consultant driven institutional marketing purposes of these institutions? No matter what the rationale, cash in equity funds is low. Dangerously low relative to the potential for further redemptions. Suffice it to say that if we encounter significant further redemptions from here, it is going to be met with selling, plain and simple. For all intents and purposes, there is no more cash with which to pay out potential redemptions.

As of now, the public has not come back to equity funds post the rally from the July lows.

This is clearly a change from equity fund consumption patterns past. Throughout the entire in process equity bear to date, resumption of equity fund inflows in the aggregate has characterized post significant rally environments. Not this time. For the sake of the aggregate economy, let's just hope that this is the only public consumption pattern that is clearly changing.

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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