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October 01, 2005

We're Awash In Liquidity (Aren't We?)

Less Room To Consume? ...We're going to find out. As you know, one of the common phrases or characterizations of the broader economic and financial markets of the moment is that "we're awash in liquidity". To be honest, we really don't dispute that description in the least. It does very well frame the global capital markets for the most part. But let's drill down just a bit a look specifically at the US consumer. Just how's the US consumer doing when it comes to liquidity, per se? Is the US consumer also awash in liquidity? And the reason we bring this up is that the US consumer is now being hit with a series of rising cost headwinds on many fronts. As we'll discuss in just a minute, the alternative minimum tax bite is now set to begin accelerating literally exponentially over the 2006-2011 period directly ahead. It's simply written in stone unless the existing tax laws are changed post haste. Moreover, higher energy costs are a reality right now and should increase in perceptual impact as winter heating bills hit mailboxes across America starting in just a few months. After levering up in a pretty big way during the current economy recovery cycle, do consumers have the liquidity reserve wherewithal to offset these all but guaranteed cost increases ahead without having to offset some type of alternative current consumption? And just how are the financial markets voting on an eventual outcome?

Let's start with a few broad perspectives of the current economic recovery to set the stage as to how the current cycle may be differing from past cycles in terms of the economy and systemic leverage as well as the economy and energy costs. The following tables spell it all out. The first is simply an update of a table we have published in the past. We're simply looking at nominal GDP growth in each period relative to the nominal increase in total credit market debt outstanding. Remember, total credit market debt includes government, corporate, household, financial sector, and state and local muni debt. The whole systemic leverage shooting match, so to speak. You already know that it has been this way for a while now in terms of dollars of systemic leverage growth compared to dollars of GDP growth. System wide leverage relative to GDP really started accelerating in the 1980's (with the baby boom generation coming of age) and has not as of yet begun to slow in terms of trajectory. To be honest, nothing new here. The current cycle is simply an acceleration relative to what has been seen in prior cycles. Can it be said that it's taking more dollars of system wide debt to produce an additional dollar of GDP at present? If that's not what the following table suggests, then what is it saying?

Although we absolutely believe that systemic leverage is a critical longer term issue for the US economy, it's probably not going to affect the financial markets at the open tomorrow in any dramatic way. Cycles of debt acceleration and reduction play out over long periods of time. Although, in our minds, this will ultimately be an issue, what is much more important is what will directly impact US consumers tomorrow. Let's bring it a lot closer to home in terms of the US consumer in the here and now. We're looking at the same economic recovery periods as above (which just happen to match the current cycle in terms of time frame). But this time we're looking at what has happened with crude prices in the first fifteen quarters of each economic recovery period. As you can see, even during the "oil crisis" days of the 1970's, acceleration in crude prices historically look like a picnic compared to what we are living through in the current cycle. A picnic. We've never experienced anything like what we see at present in crude price acceleration anywhere in the last half century at least fifteen months into an economic expansion. It's our thought that the Street has been way too complacent on how this will influence consumer decisions ahead. This IS real and this IS now. (WTIC is West Texas Intermediate Crude prices.)

We've heard it said many a time that the US economy today is much more energy efficient than was the case twenty years ago. True enough. But we need to remember that twenty years ago supply and demand characteristics of the global energy markets were much different than is the case now and looking forward. Although we believe statistics and history regarding crude prices are important, it's the price at the pump of gasoline that hits consumers directly in the pocket book in rather immediate fashion. More broadly, crude prices work into higher societal inflationary pressures over a longer period of time (petrochemicals such as fertilizers, plastics, etc.). The following chart chronicles the 24 month rate of change in average US gasoline prices over the last 25 years. As is completely clear, every single time the two year rate of change has come near or breeched 50%, the US economy has either been directly in or very near recession. (The recessionary periods are marked in red.)

Although the rebuilding and reactivation of Gulf Coast energy infrastructure is a timeline with few answers and few certainties at present, the current energy price consequences of Katrina and Rita are front and center in consumer pocketbooks right now. As you'll see in the charts below, the recent upward trajectory in prices was already firmly established well before The two hurricane sisters essentially compounded the problem.

In the chart directly below, we're using $3 per gallon as the average price of gasoline. At present, premium gas in our neck of the woods (the SF Bay Area) is already well above this number. We're currently seeing $3/gallon for low grade regular. Assuming a $3 per gallon average price of gasoline at the retail level is an accurate assumption, we're looking at a year over year price change of 55% relative to the end of August 2004. In terms of the US consumer, this is a direct hit.

We know that the upcoming winter heating season will be upon us within months. There is absolutely no question that winter heating bills will be much higher this year relative to last. After all, at recent quotes, the price of natural gas is up over 150% year over year. And at the present time, we need to realize that inventories of both gasoline and distillate products are well below what would otherwise be considered normal. Without sounding melodramatic, this is very serious. To be honest, what is released from the Strategic Petroleum Reserve is a moot point due to lack of refining capacity. And what may be realized as an increase in product imports from locales such as Europe will be a drop in the proverbial bucket. Lastly, in our minds, it's still far to early to rejoice about the hurricanes only doing limited damage to Gulf area energy infrastructure. Again, all bearishness aside, consumers face sobering heating bills this winter assuming a "normal" winter. Anything worse and the bills will border on staggering for the average family.

What you see below is the short term history of fuel oil cost per gallon. Whether for corporate needs or home heating needs ahead, we're looking at prices today more than 40% higher than last July.

We're not bringing this up in an attempt to "predict" the next US recession, but rather to suggest that the US consumer is facing stress in terms of immediate energy consumption costs. Stress that can surely be alleviated if US consumers have access to household liquidity to fund higher energy costs as an alternative to cutting back on consumption in other areas of their lives. Higher energy costs, both direct and the flow through from the energy input component to broad business costs, as well as higher implicit personal taxes due to the AMT, lie dead ahead. There's absolutely no uncertainty as to what's coming.

As opposed to looking at the consumer storms that have already made landfall, let's quickly cast our eyes offshore in a direction we believe few are looking. First, as you might remember, tucked inside the recent Bankruptcy bill is the fact that minimum credit card payments are set to increase in the very near future. As we understand the legislation, minimum 2% of principal balance payments are going to 4%. A doubling in the cash amount of minimum payments. Now we know that many a cardholder out there pays in full each month. But there are also plenty of folks sending in minimum payment checks. As of the end of June of this year, there was $2.1 trillion dollars of outstanding consumer credit balances in this country (revolving and non-revolving credit card debt). Assuming minimum payments were being made on this debt, the increase from 2% to 4% mandated minimum payments would total an increase of $42 billion monthly. Of course this is coming right in front of the 2005 holiday shopping season. Glad tidings, right? Although this is a well-known fact, we see very little attention being paid to the ramifications of this legislation on consumer spending late in '05 and continuing onto '06. Wanna bet Wal-Mart is paying full attention given their recent stock price? You better believe they are. Of course Wal-Mart are the same folks who have been yakking about higher energy costs hurting their business at the moment.

The second offshore issue which appears to us to be receiving almost zero attention on the Street at the moment is the planned acceleration in the AMT tax (alternative minimum tax) to come in 2006 and beyond. In fact, the CBO (Congressional Budget Office) anticipates that in absolute dollars, the AMT tax for Americans will roughly double in 2006. Have no worries, that's nothing. By the CBO estimates, the AMT in dollars and cents will increase 5.4 times over the next five years. The following chart is taken directly from a recent CBO report entitled, "The Budget And Economic Outlook: Fiscal Years 2006-2015". The red bars represent what the CBO believes will be cash inflows to Federal coffers as a result of the current trajectory of the AMT tax. The blue line is the number of tax returns it will ultimately affect. That number will increase six fold over the next five years. Is the general consumer base in the US even aware of this? We think not. After all, it has received just about zero media attention. That we think will change in a big way ahead. As per the CBO estimates, AMT revenues in 2005 will approximate $15 billion, growing to just shy of $100 billion by 2010. In other words, are we watching all of the consumer tax breaks enacted since 9/11 being reversed? And then some, to be honest.

Will the trajectory of AMT tax inflow estimates change ahead relative to what is seen above? There exists an Advisory Panel on Federal Tax Reform which is set to comment on this and other issues this coming fall. What is key to understand looking ahead with the current AMT as it now stands is that it is set to "reach down" well into middle class 1040's if nothing is done to change what was a law put into effect back in 1969. As per the CBO estimate chart above, another 25 million folks are set to be "touched" by the AMT during the next five years. In 2002, 2 million taxpayers got hit with AMT related cash taxes. It was 4 million taxpayers who tangled with the AMT last year. In 2006 the number is expected to mushroom to 20 million. The year over year acceleration in 2006 is huge. Again, we're convinced that the AMT is set to get a whole lot more headline coverage before it's over. For now, it's an offshore Category 1 US consumer headwind. Will it become a Cat 3 or 4 before the public starts screaming about it and demanding forced evacuation from the AMT?

Very quickly, we believe a few last tidbits from the recent CBO report deserve at least visual attention if nothing else. The following is what the CBO believes will be individual income tax liability as a percentage of GDP over the next decade. For some perspective, the average of this number in the post WWII period is 8%. We've been below that in recent years, but are set to move up and through that number substantially in the decade directly in front of us. If we assume a static GDP near the current $12 trillion, a 3% increase (from 7% to 10%) in this estimate translates into $360 billion in additional tax liability. But, of course that assumes a static GDP, which we all hope will be moving higher over time. Then so too will the dollar based tax bite. The bottom line is that the US consumer will be bearing the brunt of higher individual income taxes over time relative to any growth in the economy itself. Now do you know why we're so hung up on US wage growth trends, or lack thereof in real terms?

Finally, in relatively dramatic juxtaposition, the following is what the CBO believes will be the corporate tax burden as a percentage of GDP over the decade ahead. Hey, wait a minute. Just where is the corporate alternative minimum tax, so to speak? Corporate profits are currently a big beneficiary of a realized current corporate tax rate nearer 60 year lows than not. Looks like the good times in terms of corporate taxes realized are simply set to continue. No problem, we're sure US consumers will be more than happy to pick up any and all revenue slack at the Federal level in terms of increased individual taxes without making a peep, won't they? After all, they can just take the "profits" out of their ever-increasing residential real estate values, which are sure to rise in double digits annually over the next ten years, won't they?

We're Awash In Liquidity (Aren't We?) ...Although a lot of folks focus on the US savings rate and proclaim that US consumers are tapped in terms of access to readily available liquidity, we're going to take a differing approach. We're going to take a quick look at household liquid assets that we'll call "cash". And we'll put a very broad definition on this, not just cash in checking accounts, so to speak. Again, from the Fed Flow of Funds report, we'll use a definition for cash that includes all holdings of bank deposits (checking, savings, CD's, etc.) as well as all household ownership of fixed income instruments (MMF's, Treasuries, corporate bonds, muni's, foreign bonds, GSE bond holdings and mortgage paper owned). If that isn't a very broad and charitable definition of household liquidity, then we just don't know what is. Let's have a look at just where households stand in terms of relative "liquidity" to not only meet increasing energy and personal tax bills ahead, but also to potentially keep general consumption (retail) and real estate prices strong and rising.

As you'd guess, all of the data in the charts you see below are updated as of 2Q 2005. Very simplistically, below is household "cash" (as we've very broadly defined it) relative to household liabilities. 2Q clocked in at the lowest number on record. Nothing new here as we have been "clocking in at the lowest number on record" now every year since 1988 in literally sequential fashion.

Relative to historical context, cash as a percentage of total household assets currently rests quite near all time lows. As you know, in good measure this indicator has remained low not only because households feel the need to hold less broadly defined cash today, but also because back to back bubble-ish periods of stock and real estate price escalation have pushed total household asset values ever higher. What we find most important is the relatively steady nature of this relationship between 1950 and 1990. Clearly, prior to 1950, there were more than a few folks who had deep memories of the economic depression of the 1930's. And clearly in the 1990's, very few remember the historic dynamics of credit cycles that precipitated events such as the depression.

We can very quickly break down household cash holdings relative to the two largest household assets - common stocks (inclusive of mutual fund holdings) and real estate. First equities. We're currently at levels of household liquidity relative to equity holdings that have been seen historically much nearer market highs than lows. As perhaps a very general rule of thumb, equities are attractive relative to broadly defined cash when this ratio is above 200% and they're not so attractive when we find this number below 100%. Would this indicator work perfectly each and every year? Of course not. It's a very general look at long term cycles of attraction and avoidance of two alternative asset classes. It does not suggest an imminent drop in equities by any means, but does have something to say about the resources households might draw upon to fund further purchases, or lack of resources as the case may be.

It's no surprise at all that household levels of cash relative to real estate holdings has indeed registered an all time low as of 2Q. In fact today, we often hear in the media that folks who are letting "equity" idly sit in their homes without using it for investments (by levering up the real estate and withdrawing and "investing" the equity) are the idiots. Oh well, so go the cycles of fear and greed in any asset class, right? As always, history will ultimately be the final judge of "the idiots", and otherwise, over time.

Although we're not social psychologists by any stretch of the imagination, we're pretty darn convinced that household exposure to broadly defined liquidity is quite low today due to the blurring of the lines between cash and credit in the economy of the moment. After all, many a household has immediate access to cash via home equity lines, revolving credit, personal lines of credit, etc. Of course those alternative avenues to supposed cash or liquidity are debt in our neck of the woods. So the question stands, as consumers face higher real cash energy and personal tax costs dead ahead, how will they fund what are sure to be these increased obligations? Will they tap these alternative sources of liquidity that are in effect debt? Will they dig into what are already meager relative broadly defined cash hoards? Or will they forgo alternative consumption? In effect trading general merchandise shopping for gasoline, home heating, or personal tax bills? The answer to these questions will shape the character of the US economy in 2006, plain and simple.

We believe the important take away from looking at the data and charts above is not to suggest some type of bearish or doomsday outcome for the US financial markets and economy ahead, but rather to gauge the forward financial flexibility of US households in the aggregate. As you know, we have not even touched on topics that are sure to be very big financial issues for households as we look forward. Retirement and health care funding stand out like sore thumbs. Can we really count on the corporate or government sector to make these issues simply go away? Of course not. In fact, we feel just the opposite. It's the government and US corporate sector themselves that wish these issues would go away. Without trying to sound melodramatic, as we look forward we expect that US households will be asked not only to shoulder higher energy costs and personal tax responsibility, but also to help self fund an ever-greater portion of their retirement and medical care costs. And this will be occurring at the exact time households appear to have a relatively very low level (compared to history) of broadly defined cash or liquidity. In the end, personal financial planning is all about choices and flexibility. Are those the two things US households in the aggregate will be short on somewhere down the road? And perhaps not too far down the road?

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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