The State of U.S. Households' Balance Sheets

By: Henry To | Thu, Sep 28, 2006
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In last weekend's commentary ("Canadian Dollar Now the Lone Holdout"), I discussed that while there is a good chance that this cyclical bull market in commodities have ended (note that I believe the secular story still holds, however), I was not willing to call the end just yet as long as the Canadian dollar is still holding on. In that commentary, I stated: "... the historical correlation between the Canadian dollar and the CRB and the CRB Energy Index has been quite significant (correlation of over 50%) over the last 16 years or so. Consequently, any breakdown of the major commodity indices without the confirmation of the Canadian dollar on the downside should be viewed as suspicious. At the very least, a non-confirmation on the part of the Canadian dollar should at least lead to some kind of bounce in commodities in general. Are we about to see such a bounce - given that the Canadian dollar is still holding on? Particularly in gold or crude oil?"

As I am writing this on Sunday evening, the Canadian dollar is still holding up very well. More importantly, there is a strong likelihood that the Canadian dollar will continue to hold its own for the foreseeable future - as the Commitment of Traders report is showing that small speculators (who are historically great contrarian indicators) are now holding the smallest long position in the Canadian dollar in nearly a year. Following is the relevant chart, courtesy of

Canadian Dollar Net Commitments of Traders - Smallest long position in the Canadian dollar in nearly a year! This should at least provide some support for the Canadian dollar going forward.

As mentioned in the above chart, the fact that small speculators are now holding the smallest long position in the Canadian dollar should at least provide some support for the Canadian dollar for the foreseeable future. Moreover, given the downside non-confirmation of commodity and energy prices by the Canadian dollar, there is now a good chance for both commodity and energy prices to bounce going forward.

So Henry, which commodities are you focusing on for a bounce and in what kind of timeframe?

The obvious commodity is definitely natural gas, given the forced liquidation in the commodity that we saw over the last week by the hedge fund Amaranth as well as the fact that the crude oil-to-natural gas ratio of 8.0 ($60/7.50) is now higher than the traditional ratio of approximately 5.5 to 6.0. However, this author is still not seeing an entry point just yet, given that:

  1. Next week is the end of the quarter and thus window-dressing time, which has traditionally meant that mutual and hedge funds alike will dump their losing positions during the last quarter - which inevitably means both crude oil and natural gas positions will be dumped.

  2. The amount of natural gas inventories is now at their highest level ever for this time of the year. Combined with the fact that we are in the midst of an economic slowdown and that there has been record drilling of natural gas, and chances are that natural gas prices will continue to decline unless there is another destructive hurricane on the Gulf Coast in the next few weeks. As I have outlined in my previous commentaries, the chances of this happening is virtually nil.

  3. This author believes that there are similar hedge funds that are overextended and who have still not liquidated their long positions in energy. This upcoming week (window dressing) should thus bring more forced selling which should further depress natural gas prices.

In other words, look for a significant bounce in energy prices soon (especially in natural gas), but I am definitely waiting at least another week before even thinking about going long. Moreover, any long positions that we initiate in natural gas going forward will strictly be short-term in nature (a week to a month) - as I have also discussed in last weekend's commentary.

Let us now take care of some "laundry work." Our 50% long position in our DJIA Timing System that we initiated on the afternoon of July 18th (at a DJIA print of 10,770) was exited on the morning of August 10th at a DJIA print of 11,060 - giving us a gain of 290 points. In retrospect, this call was definitely wrong, but at that time, this author was convinced that the market was making a turn for the worst (see our August 10th commentary for further clarification). As of the afternoon on Thursday, September 7th, this author entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 123.10 points in the black. A real-time "special alert" email was sent to our subscribers informing them of this change. As of Sunday afternoon on September 24th, this author is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. Note that, however, both Wal-Mart and Sysco has had a tremendous run lately, so it may be prudent to wait for some kind of correction in these two stocks before buying if you are not already long.

I am also getting very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). The market action in large caps, retail, and technology have all been very favorable so far - and I expect it to remain favorable at least for the rest of this year. At this system, I am looking to shift from a 50% long position to a fully bullish 100% long position in our DJIA Timing System but am waiting for more clarification from my market breadth indicators (they have been getting quite weak recently). However, the market is still in an uptrend and since leadership is now shifting from small and mid caps to large caps, I am not as worried about market breadth as I would have been - say, just a mere 12 months ago. Moreover, since this rally is being led by U.S. large caps, there is no doubt that the components of the Dow Jones Industrial Average will be one of the leaders going forward. So don't be surprised if you see us going 100% long in our DJIA Timing System as early as Monday.

In this commentary, I want to give our readers a quick update on U.S. households' balance sheets, and what it may mean for the stock market going forward. Let us first start with a chart I first showed in our April 2, 2006 commentary - a chart showing the net worth of U.S. households vs. the asset-to-liability ratio of U.S. households from the first quarter of 1952 to the second quarter of 2006:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 2Q 2006) - 1) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 2) The greatest decline in households' net worth in post WWII history!

As you can see on the above chart, the net worth of U.S. households again hit a new high during the second quarter of 2006, from $53.27 trillion to $53.33 trillion - a $60 billion increase. Since the end of World War II, the net worth of American households have only experienced two notable declines - the first occasion during the 1973 to 1974 bear market and the second occasion during the 2001 to 2002 technology and telecom bust. Given that the 2001 to 2002 bust represented the greatest washout in modern American history, there is a good chance we have already seen the bottom in both the Dow Jones Industrial Average and the S&P 500 on October 10, 2002, unless there is 1) a major policy mistake by the Fed, 2) a rise of protectionist sentiment in Congress, or 3) a major war in the Middle East.

The one notable worry is the consistent increase in the leverage of households' balance sheets - as evident by the consistent decline of the asset-to-liability ratio since the first quarter of 1952. In our April 2, 2006 commentary, we stated: "Okay, we know that given the financial know-how of Americans and given the many online budgeting and "financial optimization" tools we have today, borrowing money and leveraging yourself like a U.S. corporation is now much more streamlined and is a strategy which makes perfect sense (in theory). We also know that absolute total net worth of American households continues on a secular upward trend. At the same time - as the U.S. economy switches to a service-based economy which requires a lot of formal education but is much more flexible, the business cycle has gotten less volatile. Today, our financial system is also much less vulnerable to shocks (such as the relatively muted reactions to Enron, Refco, Delphi, Delta, and GM, and so on) than 20 years ago, for example, given securitization and given the ability for financial corporations to diversify much of their sources of risks."

In that commentary, I also noted that despite all these developments and innovations, none of this fundamentally changes the fact that U.S. households now have the most leveraged balance sheets in history. Moreover, in a credit-based and financially-leveraged society such as the United States, one needs to tread very carefully if you are a central banker, and thus the last thing that the Fed wants is a declining net worth of American households. That is why both Alan Greenspan and Ben Bernanke were so fearful of a deflationary scenario back in 2002. That is why there is no question that the Federal Reserve will start to cut rates by January of next year (the Fed Funds rate are now pricing in a 40% chance of a cut during the January 30/31 2007 meetings) - and possibly even by the December 12, 2006 meeting as an "early Christmas present."

Now - assuming that:

  1. The net worth of U.S. households will continue to increase going forward; and
  2. That residential real estate will start to play a lesser role in net worth growth going forward; and
  3. That both intermediate and long-term bonds are not currently priced attractively; and
  4. Holding cash is no longer attractive once the Fed starts cutting rates again.

Then it comes to mind that the only obvious asset class that can play a significant role in shaping household balance sheets (in a positive way) going forward is equities. Moreover, since - as I have argued many times before - U.S. domestic large caps are still the most undervalued equity class in the world, it is now time for a bull market in U.S. large caps and U.S. growth stocks. This argument is also reinforced by the fact that U.S. equities today only make up 24.94% of total financial assets and 15.24% of total assets owned by households - which are at levels (with the exception of the bottom in late 2002 and early 2003) not witnessed since the second quarter of 1995 and the fourth quarter of 1994, respectively. The history of these two ratios is shown by the following quarterly chart from the first quarter of 1952 to the second quarter of 2006:

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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