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  Posted on: Thursday, May 21, 2009
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Deleveraging--U.S. vs. Japan

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We have criticized the Fed many times in these comments about not being able to recognize the bubbles in both stocks and housing that should have been so clear to investors.  When a fairly flat line, (moving around the mean by a couple of standard deviations) for many decades then rises about 4 to 5 standard deviations in just three to four years, you should be concerned about a possible bubble. Furthermore, when at the same time the asset category rises to valuation levels which have never been reached in the past, maybe you should be even more concerned about a bubble. We had both instances occur over the past 14 years---stocks (especially NASDAQ) from 1996 to 2000 and real estate from 2002 to 2006. If you notice that total credit market debt also rose to record levels relative to GDP or to Disposable Personal Income then it would have to be a no-brainer and the next step would be to understand the deleveraging process (or unwinding the debt).  


We criticized the Fed on national TV for not assigning one or two of their staff of 225 PhDs to be on the lookout for bubbles in major asset categories.  Well, we are happy to report that the San Francisco Fed recently did release a study discussing the unwinding of the debt bubble in the U.S. and comparing it to the same process Japan experienced starting in 1989 (www.frbsf.org and scroll down).   They concluded that the unwinding of the enormous debt was a very difficult process and had significant negative repercussions for the economy as a whole.  This doesn't make us as happy as they would have if they had released a letter earlier warning investors about potential bubbles.  Nevertheless, we will give them kudos for at least working on the potential repercussions of the prospective debt unwinding. 


The study charted the peak of the debt related bubble of the stock and real estate assets in Japan in 1991 (1989 for stocks and 1991 for real estate) and overlaid it with the peak of U.S. debt associated with the same assets in 2008.  They concluded that if we are able to liquidate our debt at the same rate as Japan we would have to increase our savings rate from the present 4% today to around 10% in 2018.  Japan reduced their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001.  If U.S. households were to undertake a similar deleveraging, the collective debt-to-income ratio which peaked in 2008 at 133% (H/H debt vs. Disposable Personal Income) would need to drop to around 100% by 2018, returning to the level that prevailed in 2002.


If the savings rate in the U.S. were to rise to the 10% level by 2018 (following the Japanese experience), the S.F. Fed economists calculate that it would subtract ¾ of 1% from annual consumption growth each year.  The economists also concluded that if the savings rate did not increase, but instead the deleveraging was to take place by debt defaults and debt reductions the annual consumption growth would decline even more.  In the latter case the problem would shift to the banks that hold these loans on their books.  Either way it will be very painful. 


The analysis that the S.F. Fed economists were using were Japan's non-financial debt relative to GDP (since the corporate sector was where the excess was predominant) to the  U.S. household debt relative to disposable personal income (which was where the U.S. excess was predominant).  This may not be comparing apples to apples but it is close enough for us. We would have preferred using the total credit market debt to GDP in both countries, but we also understand that these debt numbers are very difficult to extract from the Japanese authorities.   


The research paper concluded that the U.S. could go through an experience similar to that of Japan.  The Japanese stock market peaked in 1989 and their real estate market peaked in 1991.  Now, nearly 20 years later both the stock and commercial real estate market remain more than 70% below the their peaks, while residential land prices are more than 40% below their peak. Although the optimistic view is that the various stimulus plans by the new administration together with the massive easing by the Fed will help the U.S. avoid the same deleveraging result as Japan, it is exceedingly difficult to see how that will happen.


On a separate note, recent market action indicates that the bear market rally is probably over.  The earlier bear market rally off the November 21st low topped on January 6th at 944 on the S&P 500.  The current rally stopped short of that level on May 8th at 930, and a second attempt was halted at 924 intraday only yesterday, when the market turned down sharply toward the close.  Even before that, upside momentum had begun to lag while up volume was declining and down volume was on the rise.  In addition positive sentiment on the market increased at an extremely rapid rate, particularly considering the fragile nature of the so-called "green shoots" economy.  Whenever market observers latch on to catchy phrase such as that, you can almost be certain that it's wrong.  In sum, we think it's highly likely that the traditional testing of the market bottom (666) is underway.       

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