The State of U.S. Households' Balance Sheets - A Third Quarter Update

By: Henry To | Wed, Dec 13, 2006
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Dear Subscribers,

Both Rex and I appreciate all of you who have re-signed with us so far. I hope all of our subscribers had had an enjoyable week, and I hope that you "enjoyed" our commentary on asset allocation in last week's commentary. In other news, I hope that none of you was caught the wrong way in the U.S. Dollar Index trade last Friday morning. The recent slide in the U.S. Dollar Index was definitely overdone, and as I have mentioned before in my commentaries over the last two weeks, I now believe that the U.S. Dollar will generally outperform most major currencies (with the exception of the Chinese Renminbi, most "emerging Asian" currencies, and possibly the Japanese Yen) in 2007.

The reversal of the U.S. Dollar against most major currencies on Friday was also accompanied by more bullish news for the dollar. Note that I do not mean Secretary Hank Paulson's interview on CNBC about the need for a "strong dollar" (he has mentioned this many times before). What I mean is that over the week ending last Tuesday, the commercials continued to increase their short position on Euro futures contracts. As a result, the net short position of Commercials is now at a new 52-week high. Following is a chart showing the net positions of commercials, large speculators, and small speculators vs. open interest for the Euro, courtesy of

The net positions of commercials, large speculators, and small speculators vs. open interest for the Euro

Not coincidentally, the net long position of small speculators is also at a new high. Given that small speculators have historically acted as great contrarian indicators, and given that commercials are usually the "smart money," there is a good chance that the Euro reversal on Friday morning was legitimate - signaling that the U.S. dollar has probably bottomed and should rally into the end of this year and beyond into 2007.

Let us now do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 922.48 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 802.48 points

As of Sunday afternoon on December 10th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We are also very bullish on good-quality, growth stocks.

In last weekend's commentary, I discussed that the ISM Manufacturing Index is a coincident indicator, and not a leading indicator. Therefore, folks who are "relying" on the ISM, GDP, and consumer confidence numbers in order to predict the stock market going forward is playing a fool's game. Moreover, manufacturing makes up slightly less than 20% of the U.S. economy, and according to the creators and keepers of the ISM Manufacturing Index, a PMI in excess of 42% is generally indicative of an expansion in the overall economy. Therefore, the 49.5% November reading is not indicative of a contraction in the U.S. economy at all. In fact, according to the ISM, it equates to an approximate 2.4% increase in U.S. GDP. This view was vindicated when the latest ISM Services Index for November hit a level of 58.9, up from 57.1 in October and handily beating expectations of only a 56.0 reading.

Okay Henry, but the ISM Services Index is also a coincident indicator. What makes you think that we are heading for a soft landing, aside from the fact that the stock market is still going up?

In last week's commentary, I stated that: "... subscribers may remember that the U.S. stock market (as well as major stock markets around the world) did experience a significant peak on in early May of this year (during which time we were short via our DJIA Timing System) - a decline which did not end until mid-August for the most part. For the four months ending August 2006, mutual fund outflows from domestic equity funds were the highest four-month running total since the end of October 2002 (when the last cyclical bear market ended). If there had not been ample private equity buyouts or company buybacks, the Dow Industrials would have most likely gone down another 1,000 points before stabilizing. As it turned out, the "professional investors" were buying hands over fist while retail investors were bailing out in anticipation of the four-year Presidential cycle low and the annual October low. As for the world of economic leading indicators, the ECRI Weekly Leading Index had already started deteriorating in early August - suggesting that the U.S. economy was about to dramatically slow down. In other words, both the stock market and the ECRI Weekly Leading Index had successfully foreseen a mediocre GDP growth of 2.2% in the third quarter and the latest sub-50 reading in the ISM PMI."

In other words, I dispute the views by many popular commentators that the stock market is irrational, as I believed that the stock market (at least retail investors) had properly discounted the current economic slowdown during the four months ending August, when the amount of mutual fund outflows hit a record not seen since the four-month period ending October 2002. Moreover, all this current talk of market manipulation, etc, is moot - as everything this author is seeing and hearing is that both the hedge funds and retail investors are underinvested in the U.S. stock market. At the same time, many of the world's stock markets (the UK, Germany, France, Hong Kong, India, Brazil, Australia, etc., with the exception of Japan and South Korea) are still trading at or near all-time highs - suggesting that the probability of "manipulation" or "irrationality" is very much a moot point (let's face it, it is very hard to "manipulate" all the stock markets in the world at the same time).

As for other leading indicators besides the U.S. and the world's stock markets, I rely on the "Weekly Leading Index" (WLI) published by the ECRI for signs of a U.S. slowdown or recession. And right now, the annual rate of growth of the ECRI WLI is at a 26-week high at 1.8% - suggesting that while U.S. economic growth is definitely sub-par going forward, the possibility of a recession is currently very small. The economic slowdown scenario is also being confirmed by the latest UCLA Anderson School Forecast. Quoting from the LA Times article:

Despite the housing downturn, the California and U.S. economies are headed for a "soft landing" because trouble in one sector alone is not enough to trigger a recession, UCLA economists said in a quarterly forecast to be released today.

California could have a soft landing -- slowing growth but without recession -- as long as its economic woes are limited to the housing sector, economist Ryan Ratcliff said in the UCLA Anderson Forecast outlook.

"The question for how bad this thing is going to get over the next two years is whether or not something else comes along and becomes the double whammy," he said.

Leamer's national forecast devotes 14 pages to explaining why several economic models foresee recession. Then, in the final page and a half, the forecast says such models are wrong because "they can't seem to be taught that something is very different this time." In recessions, Leamer said, the manufacturing sector declines, along with construction, and the combined job and productivity losses cause recession. What's different this time, he said, is that construction is poised for a downturn, but manufacturing is "still on its knees in a deep trough." Outside manufacturing and construction, job losses in past recessions have been minimal. And, without a substantial decline in manufacturing jobs, Leamer said, "there cannot be enough job loss to qualify as real recession." His conclusion: "The models say 'recession'; the mind says 'no way.' I'm going with the mind."

Before you say that economists are always wrong and thus the UCLA Anderson School Forecast must be wrong as well, please note that the UCLA Anderson School was one of the first to forecast the 2001 recession - in December 2000 as a matter of fact, when it was still very unpopular to do so. It also had an excellent track record in predicting the seriousness of the downturn in California in the early 1990s, and the subsequent strong rebound since 1993. In other words, the track record of the UCLA Anderson School Forecast has been excellent, and there is every reason to think that the current slowdown call is "on the mark" - especially given that this author's indicators are also saying "slowdown and not recession" as well!

Let us know get on with your commentary. 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 and subsequently in our September 24, 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 third quarter of 2006:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 3Q 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! 3) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.2 today...

As you can see on the above chart, the net worth of U.S. households again hit a new high during the third quarter of 2006, up from $53.29 trillion to $54.06 trillion - a $770 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 no doubt in this author's mind that we have already seen the bottom in both the Dow Jones Industrial Average and the S&P 500 on October 10, 2002, and that the market should continue to rally from current levels, unless there is 1) a major policy mistake by the Fed, 2) a rise of protectionist sentiment in Congress, 3) a major war in the Middle East, or 4) a threat of the Bush tax cuts of 2001 and 2003 being rolled back.

On a year-over-year basis, the net worth of American households grew 6.9%, just slightly under the 54-year geometric year-over-year average of 7.4%. While this growth is definitely decent - especially in light of the "crash" in the housing markets, the one notable trend that I am continuing to worry about 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."

However, 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 also why both Alan Greenspan and Ben Bernanke has been very careful in the current hiking cycle (which most probably has already ended), in that they were 1) very transparent with their views and made sure all rate hikes were communicated in advance, 2) very careful and incremental - by choosing incremental 25 basis point hikes as opposed to the rate hike cycle during 1994 to 1995 when Greenspan hiked by 75 basis points during one meeting. Bottom line: The United States (and even more so, the United Kingdom since it does not have a great agricultural, technology, or entertainment industry such as what we have in the U.S.) today is more dependent on asset appreciation and the financial sector than ever - and both the Federal Reserve and the central banks of the world will continue to do what they can to uphold this trend going forward.

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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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