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2007 2Q Flow of Funds Update

(September 27, 2007)

Dear Subscribers and Readers,

Before we begin our commentary, I would just like to point out three Morningstar articles that should be of interest to subscribers who invest in mutual funds (a link to each of these three articles can also be found in the “Mutual Funds, Hedge Funds, and ETFs section” in our discussion forum).  For folks who are just starting to invest in mutual funds, you may be confused and overwhelmed with the number of fund families out there, and while many fund families with actively-managed funds have at least one good manager, chances are that with certain fund families (such as Dodge & Cox, T. Rowe Price, American Funds, PIMCO, etc.) there are usually many more good choices to go around.  Morningstar – in their article “Fund Families with the Best and Worst Grades” – is an assessment of each fund family's corporate governance and concern for their fund holders, and is a must-read and a great complement to what folks usually only look at – i.e. performance numbers.

Two other must-read articles from Morningstar are: 1) Initial Nominees for Fixed Income Manager of the Year, and 2) Eight Contenders for International Stock Manager of the Year.   Over the next few weeks, Morningstar will be rolling out articles on other asset categories, so stay tuned.

Let us begin our commentary and discuss the latest 2007 2Q Flow of Funds update from the Federal Reserve.  We last discussed the Flow of Funds report (as of 2006 4Q) in our March 11, 2007 commentary.  The Flow of Funds report is a quarterly publication from the Federal Reserve outlining all kinds of statistics for the U.S. economy (such as typical balance sheet and income statement data) and is broken down into the household, non-profit, corporate, and government sectors.  In essence, this publication is the “10-Q of the U.S. economy” and is therefore one of the most important documents that are published on the U.S. economy on a quarterly basis (even though it is somewhat backwards-looking since the data isn't usually released until nearly three months after the fact).  Let us first discuss the balance sheet of U.S. households – starting with a chart showing the absolute amount of net worth of U.S. households vs. their asset-to-liability ratio from 1Q 1952 to 2Q 2007:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 2Q 2007) - 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 5.19 today... 5) Household net worth rose 7.8% on a year-over-year basis to an all-time high of $57.9 trillion. 6) The *dip* in net worth caused by the October 1987 stock market crash.

As mentioned on the above chart, total U.S. household net worth rose another 7.8% on a year-over-year basis to an all-time high of $57.9 trillion as of June 30, 2007.  While this latest appreciation has not been as brisk as the average appreciation from the third quarter of 2003 to mid 2006 (it had averaged nearly 10% during that period, due to strong real estate and equity prices), it is still very respectable – especially given the slowdown in the U.S. housing market and the below-trend economic growth we have witnessed over the last 12 months.  Moreover, this latest appreciation was accompanied by a steady reading in the asset-to-liability ratio of 5.19 over the last three quarters (it bottomed out at 5.18 as of the third quarter of 2006) – as the growth of home mortgage debt slowed to 7.99% over the last 12 months, down from a 13.8% rate in 2005.  However small it may be, this latest decline in the leverage of households' balance sheets is definitely a welcome sign, even though signs of deleveraging are never good over the short-run (in this case for the housing markets, over the next several quarters).  Note, however, that the secular decline in the asset-to-liability ratio of U.S. households remains intact.

Another take-over from the above chart is not just the fact that American households are getting into more debt every year, but also that the U.S. economy is now hugely (and increasingly) dependent on asset appreciation to fund future consumption – whether it is appreciation of one's home, 401(k), or private business.  Given the latest 7.8% year-over-year appreciation in households' net worth as of June 30th, the concept of the “never-dying” US consumer remains intact, for now.  However, since June 30th, we have witnessed a significant correction (and increasing volatility) of equity prices – not to mention a slight across-the-board decline (and continuing weakness) in U.S. housing prices.   At the same time, crude oil is now over $80 a barrel.  While the chances of a consumer recession has now risen significantly over the last six months, we are not betting on such a scenario just yet – we prefer to see more data (e.g. higher unemployment claims) roll in over the next few weeks before we will make such a decision.

Speaking of real estate prices, the following chart shows the value of real estate held by US households and nonprofits as a percentage of total assets versus the quarter-to-quarter change in the OFHEO Housing Price Index from 2Q 1975 to 2Q 2007:

Real Estate held by Households and Nonprofits as a Percentage of Total Assets vs. the Quarter-to-Quarter Change in the OFHEO House Price Index (2Q 1975 to 2Q 2007) - 1) The latest increase in housing prices (0.08%) per the OFHEO HPI - represents the 5th straight quarter of below average growth in U.S. housing prices. Despite these mediocre increases, however, real estate as a % of household assets is still near a record high at 29.30% - barely below the record high of 30.29% reached during the second quarter of 2006. 2) Previous record quarterly increase - which was nearly surpassed by the increase during the third quarter of 2004!

As mentioned on the above chart – while the OFHEO Housing Price Index has now grown below trend for the last five quarters – the percentage of household assets held in real estate is still near the record high achieved during the second quarter of 2006.  Given this statistic, it is highly likely that housing prices will not only grow below trend, but will decline going forward as well.  Assuming that this statistic reverts back to its historical average of approximately 25% of total household assets, then this would mean a $2 trillion write-down in US household balance sheets (in real terms) going forward.

In order for the US not to experience a consumer-led recession, at least one of the following two things will need to occur: 1) another downtick in unemployment levels and a rise in US household wages going forward, or 2) A higher-than-expected rise in the S&P 500 over the next 12 to 18 months, and preferably accompanied by lower interest rates.  At this point – given the latest deterioration in the financial and auto sectors, it is difficult to envision U.S. wages ticking higher over the next 12 to 18 months.  Therefore, the best option to “bail out” the U.S. consumer is rising equity prices.  While this author is still looking for a correction going forward, it is important to keep in mind that another higher-than-expected uptick in U.S. stock prices over the next 12 to 18 months is not out of the question, as illustrated in the following chart (showing the amount of equities and mutual funds held by U.S. households as a percentage of their total and financial assets):

Equities and Mutual Funds as a Percentage of Total Household Assets (1Q 1952 to 2Q 2007) - 1) As a percentage of total household assets, equities *only* make up 15.72% - slightly above its 55-year average of 15.28%. Probability suggests that the cyclical bull market still has further to rally until *exhaustion* sets in. 2) As a percentage of total financial assets owned by households, equities *only* make up 25.44% - slightly above its 55-year average of 23.78% and is in line with its average (25.32%) over the last three years.

Given that U.S. households have continued to shun equities over the last five years – despite the end of the cyclical bear market in October 2002 – there is a chance that we could see a higher-than-expected uptick in U.S. equity prices over the next 12 to 18 months.  However, if such a scenario does not materialize anytime soon – and should this author's “correction scenario” pan out, then we could actually be looking at a consumer-driven recession in the US for the first time since 1991.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

 

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