Comstock Partners, Inc.October 13, 2011
More Important than Historical Statistics--Private Debt Decline
Accumulations and Liquidations of Debt
We have seen some statistically significant results from very wise stock market pundits where anyone would be foolish not to be cognizant of the results. These results are important, but not nearly as important as what is taking place in the macro picture with the accumulation and/or liquidation of U.S. debt both public and private. It is our opinion that the accumulation of debt (usually accompanied by inflation) and the liquidation of debt (usually accompanied by deflation) are the most important statistics we should monitor for the direction of the economy and ultimately the stock market. We believe the private debt decline that has already started will continue, and be led by the consumers who are reigning in their spending habits, saving more, and paying off (or defaulting on) their enormous debt. Although it might seem that deleveraging would be beneficial for our economy, almost certainly any decline from present debt levels will not be "orderly" and consumer demand will contract sharply.
Ned Davis Research (NDR) is well known by all of our viewers as we frequently use their research and charts in commentaries. They did a study that took place one year after the S&P 500 (S&P) declined by 14% in just one quarter (as it just did). They found that since the 1920s the S&P lost 14% in one quarter 21 times, and the following year the S&P rose 13% on average. And if you just included the 14% quarterly losses since WWII, the S&P would be even greater or + 23%. The conclusion of this analysis would have to make you more positive on the stock market.
Another statistical observation arrived at by an equally impressive stock market visionary, Ed Hyman of Institutional Strategy and Investment (ISI), was not as positive. He stated this past week that there were seven times since WWII that the S&P 500 dropped 20% or more, and a recession followed in 5 of the 7 times. The exceptions were 1987 and 1998. Since the S&P 500 just dropped almost 20% from 4/29/11 to 10/3/11, he concluded that there is about a 70% chance that the economy would be headed for a recession (5/7= 71%).
We have also looked at studies that showed mixed results. For example, a study showing what took place in the past after the S&P 500 dropped for 5 consecutive months (which you will be surprised to hear just took place) showed the market rising over the following year. However, when it did decline it fell sharply. The latest economic news came in a little better than expected so that could be encouraging for the bulls, but we believe there is a much more relevant statistic to monitor that is significantly more important than these micro studies and statistics.
History of Inflations and Deflations or Accumulations and Liquidations of Debt
We do not think that these studies and economic releases are as relevant as what is going on in the inflation vs. deflation battle that has taken place over the past 100 years. This country has gone through only one period of time that is comparable to what is taking place presently. We are talking about how extreme our total debt relative to GDP has reached. Our total debt rose to about 260% of GDP during the Great Depression at its peak before collapsing. The private debt was liquidated during the 1930s as deflation took hold and the country suffered more than at any time since the Civil War. Our government debt started rising sharply, as you would expect, during World War II, and winning that war gave us the will to pay down much of the debt built up during the war. Our culture and way of living stayed pretty tame for many years after the inflation and deflation of the Great Depression. You have to remember that we paid a large portion of our home purchase prices at that time, and didn't have credit cards that we could abuse.
However, starting in the early 1980s and coincidental with the start of "Star Wars" our total debt relative to GDP started growing faster. In the 1990s the growth rate of our debt relative to GDP accelerated as we bought more goods and services than we needed. Many of U.S. consumers felt invulnerable as the stock market delivered record returns as the valuation of dot com stocks rose to 245 times earnings, and the S&P rose to over 32 times earnings (over 50% more than at prior peaks).
The stock market broke in the year 2000 and we believed that the debt build up would finally peak and decline with the stock market as the total debt to GDP reached the same level as the peak in the Great Depression of 260%. We believe that if the powers that were in charge at the time just allowed the free market to work, the debt levels would have declined to levels that could have been manageable as the consumers rebuilt their balance sheets. Instead, they tried to control the decline by lowering Fed Funds to 1% in mid 2003 and started a housing bubble that coincided with another stock market bubble. Actually their interference was responsible for growing the debt at the highest rate in all of U.S. history. This is when total debt more than doubled by rising from $26 trillion in 2000 to almost $53 trillion in 2008, as both public and private debt skyrocketed. Private non-financial debt rose from $17.5 tn. to 36.4 tn. and public debt (including State and Local) rose from $7.2 tn. to $12.3 tn. As we expected, the public debt continued to grow from 2008 to present, rising to about $17.8 tn. now (this counts Government debt used to replace the Social Security fund that was confiscated, but doesn't count the implied guarantees of our government of institutions like Fannie Mae and Freddie Mac).
The Government Debt rose over $5.5 trillion since 2008, but the Private Debt declined by close to $5 trillion during the same period of time. This is the first time since the Great Depression that private debt declined at all-even a dime. A significant part of Private Debt came from Consumer Debt where the revolving and credit market debt declined about $140 billion (from $2.6 tn. to $2.45 tn. ) and the total household debt declined from $14 tn. to $13.3 tn. The Total Credit Market Debt declined only about $500 bn. and since the Federal Debt has increased by $4.2 trillion since 2009, it is clear that the total Private Debt decreased by close to $5 trillion since the beginning of 2009.
Another debt-by-the-decade study done by Ned Davis Research (attached table) showed the amount of debt it took to generate the total GDP for the decade. It showed the total debt to generate the total GDP for the decade of 1949 -to- 1959 was $337.6 bn. to generate the $248 bn. of GDP or Debt/GDP of 1.36. (The ratio essentially shows how much debt it takes to generate $1 of GDP. The ratio from 1959 to 1969 was 1.53, the ratio from 1969 to 1979 was 1.68, 2.93 from 1979 to 1989, 3.12 from 1989 to 1999 and 6.02 from 1999 to 2009. So you can see the tremendous increase of debt needed to generate GDP starting in 1980 and accelerating up into the first decade of 2000.
Although we have frequently discussed the above statistics in past commentary, we presented them again to provide a backdrop for the recent dramatic decline in private debt. We find it incredible that there was not one quarterly decline in household debt since 1952 (as far back as we could find data) until the third quarter of 2008 from where we've had 12 consecutive quarterly declines. We didn't even have one quarter of decline during the worst recessions since the Great Depression (up until the recent Financial Crises in 2008) in 1973-74 and 1981-82-- NOT ONE!! During the period from the year 2000 to 2008 household debt rose from 68% of GDP to 100% of GDP. But, since the 3rd quarter of 2008 we had 12 consecutive quarterly declines as total household debt declined by almost $1 tn.
Now that the credit binge has ended, we expect consumer demand to continue declining. As the consumer continues to retrench, we expect the household debt to decline below $10 tn. from $13.3 tn. now. With the deprivation of this consumption power which has been the backbone of the U.S. economy for the past 75 years, the economy can be expected to enter a double dip recession.
Charts supplied by Ned Davis Research (NDR).